Gov Sovereigns/Treasurys

Dear Client, This will be the last Global Investment Strategy report of 2018. Publication will resume on January 4th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Feature 1.  Will the Fed raise rates more or less than what is priced into the futures curve? Answer: More. The fed funds futures curve is pricing in less than one rate hike in 2019 and rate cuts beyond then. In contrast, we think the Fed will raise rates three or four times next year and continue hiking into 2020. For all the worries about a slowdown, U.S. real GDP growth is still tracking at 3% in Q4 according to the Atlanta Fed, while consumption is set to rise by 4.1%. Ongoing fiscal stimulus, decent credit growth, rising wages, and a decline in the savings rate should continue to support the economy in 2019. Housing construction should also stabilize thanks to a low vacancy rate and a pickup in household formation. The fact that mortgage applications for purchase have rebounded swiftly in recent weeks is evidence that the housing market is not as weak as many people believe (Chart 1). Chart 1U.S. Housing: No Oversupply Problem, While Demand Is Firming U.S. Housing: No Oversupply Problem, While Demand Is Firming U.S. Housing: No Oversupply Problem, While Demand Is Firming 2.  Will U.S. 10-year Treasury yields rise more or less than expected? Answer: More. Treasurys almost always underperform cash when the Fed delivers more rate hikes than the market is discounting (Chart 2). We expect a modest bear flattening of the yield curve in 2019, with rising bond yields nearly offsetting the increase in short-term rates. Most of the flattening is likely to come in the next six months, as slower global growth and the disinflationary effects of lower oil prices keep bond yields contained. As we enter the second half of next year, global growth should reaccelerate as the effects of Chinese stimulus measures fully kick in and the drag on global growth from the recent tightening in financial conditions dissipates. By that time, the U.S. unemployment rate will be in the low 3% range, a level that could trigger material inflationary pressures. Chart 2Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected 3. Will the yield spreads between U.S. Treasurys and other developed economy bond markets widen? Answer: Yes, particularly at the short end of the curve. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will support wider differentials between Treasurys and non-U.S. bond yields. The greatest potential for spread widening will be for Treasurys versus JGBs. With Japanese inflation still stubbornly low and fiscal policy set to tighten from a hike in the sales tax, the BoJ will be in no position to abandon its yield curve control regime. The 10-year Treasury-gilt spread could also widen if the Bank of England is forced to stay on the sidelines until Brexit uncertainty is resolved. Likewise, the U.S.-New Zealand spread will widen as the RBNZ stays on hold due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be range-bound, with the Bank of Canada coming close to matching, but not surpassing, Fed tightening in 2019. While the ECB will refrain from raising rates next year, the U.S. Treasury-German bund spread should narrow marginally if the end of ECB QE lifts bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads, as both the RBA and Riksbank begin a tightening cycle. 4. What will happen to U.S. corporate credit spreads? Answer: They are likely to finish 2019 close to current levels. As a rule of thumb, corporate bond returns are highest when the yield curve is very steep, and lowest when it is inverted (Table 1). The former generally corresponds to the early stages of business-cycle expansions, while the latter encompasses the period directly preceding recessions. We are still in the intermediate phase, when excess corporate bond returns (relative to cash) are positive but low. This conclusion is consistent with the observation that corporate balance-sheet leverage has increased over the past four years, but not by enough to instigate a major wave of defaults. Table 1Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions 5. Will the U.S. dollar continue to strengthen? Answer: The dollar will strengthen until the middle of 2019 and then begin to weaken. Three main factors determine the short-to-medium term direction of the dollar: 1) momentum; 2) interest rate spreads between the U.S. and its trading partners; and 3) global growth. In general, the dollar does well when it is trending higher, spreads relative to the rest of the world are wide and getting wider, and global growth is slowing (Chart 3). For the time being, momentum continues to work in the greenback’s favor. Spreads have narrowed a bit recently, but the dollar still looks cheap relative to what one would expect based on the current level of spreads (Chart 4). As in 2017, the direction of global growth will likely be the key driver of the dollar next year. If growth bottoms in mid-2019, as we expect, the dollar will probably put in a top. Chart 3Dollar Returns Driven By Momentum, Rate Differentials, And Global Growth 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 4Wider Spreads Bode Well For The Dollar Wider Spreads Bode Well For The Dollar Wider Spreads Bode Well For The Dollar   6. Will global equities rise or fall? Answer: Rise. Our tactical MacroQuant stock market timing model finally moved back into neutral territory on Monday after having successfully flagged the correction that began in October (Chart 5). Having downgraded global equities this past summer, we will return to overweight if the ACWI ETF drops to $64, which is only 2.4% below yesterday’s close. The cyclical backdrop for stocks is reasonably constructive. We expect the MSCI All-Country World Index to rise by about 10%-to-15% in dollar terms from current levels by the end of 2019. The higher end of this range would leave it slightly below its January 2018 peak (Chart 6). The index is currently trading at 13.3-times forward earnings, similar to where it was in early-2016. The U.S. accounts for over 50% of global stock market capitalization (Chart 7). As such, the U.S. equity market tends to influence non-U.S. stocks more than the other way around. Sustained U.S. equity bear markets are rare outside of recessions (Chart 8). With another U.S. recession unlikely to occur at least until late-2020, that gives global stocks enough room to rally. Indeed, history suggests that the late stages of business-cycle expansions are often the juiciest for equity investors (Table 2).  Chart 5The MacroQuant Equity Score* Improves To Neutral 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 6Global Stocks Have Cheapened Global Stocks Have Cheapened Global Stocks Have Cheapened Chart 7The U.S. Is The Dominant Equity Market 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 8Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap     Table 2Too Soon To Get Out 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions 7. Will cyclical stocks outperform defensives? Answer: Yes, although this is likely to be more of a phenomenon for the second half of 2019. Cyclicals typically outperform defensives when bond yields are climbing (Chart 9). Rising bond yields are usually a sign of stronger growth — manna from heaven for capital goods and commodity producers. As long as global growth is under pressure, cyclicals will struggle. But once growth bottoms in the middle of next year, cyclical stocks will have their day in the sun. Chart 9Cyclicals Tend To Outperform When Yields Rise Cyclicals Tend To Outperform When Yields Rise Cyclicals Tend To Outperform When Yields Rise 8. Will U.S. equities continue to outperform other global stock markets? Answer: Yes, but probably only until mid-2019. The U.S. stock market has less exposure to cyclical sectors such as industrials, materials, energy, and financials than the rest of the world (Table 3). Therefore, it stands to reason that an inflection point for cyclicals versus defensives will correspond to an inflection point for U.S. versus non-U.S. stocks. If this were to happen, it would resemble the period between October 1998 and April 2000, a time when bond yields rose, the dollar rally stalled, cyclicals outperformed defensives, and non-U.S. equities outperformed (Chart 10). Table 3Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials And Materials Are Overrepresented In Markets Outside The U.S. 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 10Will The Late-1990s Pattern Be Repeated? Will The Late-1990s Pattern Be Repeated? Will The Late-1990s Pattern Be Repeated?   9. Will oil prices rise more than expected? Answer: Yes. The December-2019 Brent futures contract is currently trading at $61/bbl (Chart 11). Our energy strategists expect Saudi Arabia and Russia to cut production by enough to push prices to an average of $82/bbl in 2019. Looking further out, the outlook for oil prices is less favorable. As every first-year economics student learns, prices in a competitive market eventually converge to average costs. Shale companies are now the swing producers in the global petroleum market. Their breakeven costs are in the low-$50 range, a number that has been trending lower due to productivity gains. If that is the long-term anchor for oil prices, it means that any major rally in oil is unlikely to extend deep into the next decade. Chart 11Oil Prices Will Recover Oil Prices Will Recover Oil Prices Will Recover 10. Will gold prices finally rally? Answer: Yes, but only in the second half of 2019. Gold prices typically fall when the dollar is strengthening (Chart 12). Given our view that the dollar will rally into mid-2019, now is not the time to be loading up on bullion. However, once the dollar peaks and U.S. inflation moves decidedly higher late next year, gold should become a star performer. Chart 12Gold Will Shine Bright After The Dollar Peaks Gold Will Shine Bright After The Dollar Peaks Gold Will Shine Bright After The Dollar Peaks     Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Dear Client, This is the final Global Fixed Income Strategy report for 2018. We will return with our first report of the new year on January 8th, 2019. Our entire team wishes you a very happy holiday season and a prosperous new year. Best regards, Rob Robis, Chief Strategist 2019 Model Bond Portfolio Positioning: Translating our 2019 key global fixed income views into recommended overall positioning within our model bond portfolio yields the following: target a modest level of active portfolio risk, with below-benchmark duration and only neutral exposure to corporate credit. Country Allocation: Government bond allocation should continue to reflect relative expectations for monetary policy changes. That means an overweight in countries where central banks will have little scope to increase rates (core Europe, Japan, the U.K., Australia, New Zealand) and an underweight where central banks are likely to tighten more than markets currently discount (U.S., Canada, Sweden). Corporate Credit: We currently prefer U.S. corporate bonds to European and EM equivalents based on better U.S. profit prospects, which enhances debt serviceability. However, we will look to pare U.S. exposure as the Fed shifts to a more restrictive stance later in 2019. Feature Last week, we published our 2019 “Key Views” report, outlining the thematic implications of the 2019 BCA Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations for next year. We also recommend changes to the allocations in the Global Fixed Income Strategy model bond portfolio to reflect our 2019 themes. The main takeaway is that 2019 will be another year of poor returns, with increased volatility, for most global fixed income markets. The greater pressures should come in the latter half of the year, after the U.S. Federal Reserve delivers additional rate hikes and decisive signs of a slowing U.S. economy unfold. Investors should maintain a defensive strategic posture on fixed income markets throughout the year, both for interest rate duration and credit exposure. Selling into market rallies, rather than chasing them, will prove to be the prudent strategy. Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from last week’s Key Views report were the following: Late-cycle pressures will keep bond yields elevated. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for both government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay modest in 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. We now present the specific fixed income investment recommendations that flow from those themes in the following categories: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Risk: DEFENSIVE Government bond yields enter 2019 at very low (i.e. expensive) levels across the major developed markets, even after the cumulative rise in U.S. Treasury yields seen over the past twelve months. Real yields remain below trend real GDP growth rates, a consequence of central banks keeping policy rates below neutral levels as measured by concepts like the Taylor Rule (Chart of the Week). In addition, credit spreads remain near the low end of long-run historical ranges in all markets. Without the initial starting point of cheap valuations, fixed income return expectations in 2019 should be severely tempered (Charts 2& 3). Chart 1   Chart 2Low Yields = Low Expected Returns For U.S. Corporates … Low Yields = Low Expected Returns For U.S. Corporates... Low Yields = Low Expected Returns For U.S. Corporates...   Chart 3… And European Corporates ...and European Corporates ...and European Corporates Volatility measures like the VIX index will remain elevated until markets begin to sniff out a bottoming of global growth. Much will depend on developments in China, but our expectation is that policymakers there will only act to stabilize the economy rather than provide large, 2016-scale stimulus. That may be enough to create a tactical “risk-on” trading opportunity by mid-year but we recommend using any such rally to reduce credit exposure given the risk of a more lasting global economic downturn in 2020. Importantly, cross-asset correlations should continue to drift lower without broad support from coordinated global economic growth or expanding monetary liquidity via central bank asset purchases (Chart 4). Without those rising tides lifting all boats, more active security selection by country, sector and credit rating should help portfolio managers outperform their benchmarks in what is likely to be another down year for absolute returns. Chart 4High Volatilities With Low Correlations High Volatilities With Low Correlations High Volatilities With Low Correlations That combination of diminished return prospects and elevated volatility means investors should maintain a defensive bias in fixed income portfolios heading into 2019. Within our own GFIS recommended model bond portfolio, this means keeping our tracking error (the relative expected volatility versus our custom benchmark performance index) well below our maximum target level of 100bps (Chart 5). Chart 5Maintain Moderate Overall Portfolio Risk Maintain Moderate Overall Portfolio Risk Maintain Moderate Overall Portfolio Risk Overall Duration Stance: BELOW BENCHMARK We do not think that global bond yields have peaked for this business cycle. The current period of softening global economic momentum will not turn into a prolonged period of sub-trend growth that would push up unemployment rates in the major developed economies. With the global output gap nearly closed, and monetary policymakers firmly believing in the Phillips Curve framework (lower unemployment leads to higher inflation) to forecast inflation, a more dovish stance from the major central banks seems unlikely. As we discussed in last week’s report, global bond yields are in a process of normalization away from the depressed levels seen after the 2008-09 global financial crisis and recession (Chart 6). Term premia, inflation expectations and real yields all have upside potential as central banks slowly back away from quantitative easing and low interest rate policies. Thus, we continue to recommend a defensive, below-benchmark strategic stance on overall portfolio duration exposure (Chart 7). Chart 6Bond Yields Will Continue To Normalize In 2019 Bond Yields Will Continue To Normalize In 2019 Bond Yields Will Continue To Normalize In 2019   Chart 7Stay Below-Benchmark On Duration Risk Stay Below-Benchmark On Duration Risk Stay Below-Benchmark On Duration Risk Government Bond Country Allocation: Underweight U.S., Canada, Sweden, Italy. Overweight Germany, France, U.K., Japan, Australia, New Zealand At the country level, we recommend underweighting government bond markets where central banks will be more likely to raise interest rates (because of firm domestic economic growth and building inflation pressures), but where too few rate hikes are currently discounted in money market yield curves. The U.S., Canada and Sweden fit that description (Chart 8). The U.K. would also be part of this group, but the Brexit uncertainty leads us to maintain an overweight stance on U.K. Gilts entering 2019. Chart 8Monetary Policy Expectations Drive Country Allocations Monetary Policy Expectations Drive Country Allocations Monetary Policy Expectations Drive Country Allocations By the same token, we are recommending overweights in countries where rate hikes are unlikely to occur in 2019 because of underwhelming inflation, like core Europe, Japan and New Zealand. We are currently overweight Australian government bonds, but we expect to cut that exposure in 2019 as pressure builds for a rate hike in the latter half of the year as inflation picks up. Italian government bonds represent a special case of a developed market trading off sovereign credit risk rather than interest rate or inflation risk. We continue to treat Italian government bonds the same way we view corporate debt, as a growth-sensitive asset. On that basis, we will remain underweight Italian government bonds until Italy’s leading economic indicator bottoms out, mollifying concerns about debt sustainability. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will sustain wide differentials between Treasuries and non-U.S. bond yields (Chart 9). Chart 9ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets The greatest potential for spread widening will be for Treasuries versus JGBs, with no changes in the Bank of Japan’s monetary policy expected due to stubbornly low inflation. The 10-year Treasury-Gilt spread could also widen if the Bank of England stays on the sidelines for longer until Brexit uncertainty is resolved. The 10-year U.S.-New Zealand spread should also widen with the Reserve Bank of New Zealand staying on hold for a while due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be rangebound, with the Bank of Canada likely to match, but not exceed, Fed tightening in 2019. There are some markets, though, where yields could rise a bit more than Treasury yields due to shifting monetary policies. While the ECB will refrain from raising rates next year, there is a potential for the U.S. Treasury-German Bund spread to narrow marginally if the end of ECB new asset purchases lifts Bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads. After keeping monetary policy very loose for a long time, the beginning of rate hikes next year by the Reserve Bank of Australia and Riksbank could put meaningful upward pressure on deeply depressed longer-maturity Australian and Swedish yields. Yield Curve Positioning: Favor Bearish Steepeners Everywhere In The First Half Of 2019, Then Switch To Bearish Flatteners In The U.S., Canada, Australia And Sweden We expect some bearish steepening pressures to appear in most countries in the first quarter of 2019 with inflation breakevens likely to rebound if the bullish oil forecast of BCA’s Commodity & Energy Strategy team comes to fruition (Charts 10 & 11). The end of the net new buying phase of the ECB’s Asset Purchase Program in January will also put upward pressure on longer-dated European yields through a worsening supply/demand balance for European government bonds and a wider term premium, helping keep European yield curves steep. Chart 10Inflation Expectations & Bond Yields Will Rebound In 2019 … Inflation Expectations & Bond Yields Will Rebound In 2019... Inflation Expectations & Bond Yields Will Rebound In 2019...   Chart 11… As BCA’s Bullish Oil View Comes To Fruition ...As BCA's Bullish Oil View Comes To Fruition ...As BCA's Bullish Oil View Comes To Fruition Importantly, it is too soon to worry about an inversion of the U.S. Treasury curve, as we discussed in last week’s report, with the fed funds rate not yet at a restrictive level (i.e. real rates above measures of neutral like R-star). That outcome should occur by the end of 2019, when we expect the Treasury curve to move towards a true monetary policy-induced inversion. Similar patterns – steepening first from rising inflation expectations, flattening later from more hawkish central banks delivering rate hikes – should unfold in Canada, Australia and Sweden. Applying Our Global Golden Rule To Government Bond Allocations Back in September, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.”2 This is an extension of a framework introduced by our sister service, U.S. Bond Strategy, that links U.S. Treasury returns to changes in the fed funds rate that are not discounted in money markets (using our 12-month Discounters derived from Overnight Index Swap curves). In Table 1, we show the expected returns generated by the Global Golden Rule (shown hedged into U.S. dollars) for the countries in our model bond portfolio custom benchmark, based on monetary policy scenarios that we deem to be most plausible for 2019. In Table 2, we show the returns on a duration-adjusted basis (expected total return divided by duration). We then rank the return scenarios for overall country indices, aggregating the returns of the individual yield curve maturity buckets shown in those two tables, in Table 3. Table 1Global Golden Rule Return Forecasts For 2019 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense   Table 2Global Golden Rule Duration-Adjusted Return Forecasts For 2019 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense The shaded cells in Table 3 represent our base case forecasts for policy rate changes in each country. On this basis, the better return prospects for 2019 will be in markets where central banks will stand pat throughout the year (Germany, Japan). Conversely, the weaker returns will occur where we expect more rate hikes than currently discounted by markets (U.S., Canada). These returns fit with our recommended country allocation outlined above. Table 3Ranking The 2019 Return Scenarios 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense Corporate Credit Allocation: Neutral Overall, But Overweight In U.S. Investment Grade And High-Yield Relative To European And Emerging Market Equivalents. Look To Cut The U.S. To Underweight In The Latter Half Of 2019. We enter 2019 maintaining our recommended overall neutral exposure to corporate debt. As discussed earlier, we expect to see some stabilization of global growth in the first half of 2019. This will create a playable “risk-on” rally for growth sensitive assets like corporates, but we anticipate selling into that rally by downgrading our recommended U.S. credit allocations to underweight. Within U.S. credit markets, we are recommending a less aggressive medium-term stance, staying up in quality within investment grade debt (single-B and single-A rated names versus BBBs) and high-yield (BB-rated vs CCC-rated). With 50% of the investment grade benchmark index now rated just above junk, there is a growing risk of “fallen angel” downgrades to junk status in the event of a material slowing of U.S. economic growth. At the same time, default-adjusted spreads on U.S. high-yield debt only appear attractive if the current exceptionally low default rate backdrop persists (Chart 12). In other words, both U.S. investment grade and high-yield corporate debt are vulnerable to any major slowing of U.S. economic growth and slump in corporate profits. Chart 12U.S. Corporates Vulnerable To Slower Growth U.S. Corporates Vulnerable To Slower Growth U.S. Corporates Vulnerable To Slower Growth The confluence of above-trend U.S. growth and still pro-cyclical Fed policy will support U.S. credit in the near-term, but that will all change later in 2019. We expect the Fed to deliver at least 75bps of rate hikes in 2019 – perhaps only pausing from the current 25bps per quarter pace at the March meeting – which will push the funds rate into restrictive territory and invert the Treasury curve sometime in the 4th quarter of the year. This will cause investors to start to discount a deep growth slowdown in 2020, which will trigger systemic credit spread widening (Chart 13). We expect our next move on U.S. corporate debt to be a downgrade to underweight, likely sometime around mid-year. Chart 13Growth Differentials Continue To Favor U.S. Growth Differentials Continue To Favor U.S. Growth Differentials Continue To Favor U.S. We still prefer U.S. corporates to European or Emerging Market (EM) equivalents, however, thanks to the likelihood of better near-term growth prospects in the U.S. We are concerned about how the European corporate bond market will perform without the support of ECB asset purchases, which leads us to underweight both investment grade and high-yield European corporates (Chart 14).3 Chart 14Stay Overweight U.S. Corporates Vs European Corporates Stay Overweight U.S. Corporates Vs European Corporates Stay Overweight U.S. Corporates Vs European Corporates EM corporates will continue to suffer from the toxic combination of rising U.S. interest rates, a stronger dollar and global growth concerns. Our political strategists remain skeptical on the prospects for a permanent deal on thorny U.S.-China trade issues, leaving EM assets exposed to slowing momentum in China’s economy. We continue to prefer owning U.S. credit, given how the relative performance of EM and U.S. credit has not yet converged to levels implied by U.S./EM growth differentials (Chart 15). Chart 15Stay Overweight U.S. Corporates Vs EM Corporates Stay Overweight U.S. Corporates Vs EM Corporates Stay Overweight U.S. Corporates Vs EM Corporates Model Portfolio Adjustments To Begin 2019 In terms of our model bond portfolio, we recommend a few changes to our current allocations to reflect our 2019 outlook and key views (see the table below). We make a few adjustments to our individual country duration allocations, given our expectations of some re-steepening of global yield curves. We also bump up our allocation to core European debt given our expectation that the ECB will keep policy rates on hold throughout 2019. We fund that increase in European exposure from U.S. Treasuries, where too few Fed rate hikes are now discounted. Finally, we make a modest adjustment to our U.S. high-yield allocations, cutting CCC-rated exposure and upgrading B-rated credit.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “2019 Key Views: Normalization Is The “New Normal””, dated December 12th 2018, available at gfis.bcarsearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “The Global Golden Rule Of Bond Investing”, dated September 25th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “Stubbornly Resilient Bond Yields”, dated November 13th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Late-cycle pressures will keep pushing bond yields higher. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay benign through 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. Feature BCA’s annual Outlook report, outlining the main investment themes that will drive global asset markets in 2019, was sent to all clients in late November.1 In this Weekly Report, we discuss the four broad implications of those themes for global fixed income. In a follow-up report to be published next week, we will translate those themes into strategic investment recommendations and allocations within our model bond portfolio framework. Key View #1: Late-Cycle Inflation Pressures Will Keep Pushing Bond Yield Higher The main theme from last year’s BCA Outlook was that markets and policy would collide in 2018. This year’s Outlook concluded that those same frictions would persist in 2019, and for similar reasons. The global economy is likely to see another year of above trend growth, after the current deceleration phase bottoms out in the first half of the year. Tight labor markets will continue to force developed market central banks, who still strongly believe in the Phillips Curve relationship as the best way to forecast inflation, to move toward less dovish monetary policies, putting steady upward pressure on global bond yields. Our own Central Bank Monitors signal a need for tighter monetary policy (Chart of the Week), most notably in the U.S. That may sound strange given the recent softening of global growth momentum and plunge in oil prices. Yet economic survey data (like the global ZEW index) show a huge divergence between actual and expected growth, with real bond yields responding more to the former than the latter (Chart 2). Chart of the WeekStill A Bearish Bond Backdrop Still A Bearish Bond Backdrop Still A Bearish Bond Backdrop   Chart 2Global Yields Will Remain Resilient In 2019 Global Yields Will Remain Resilient In 2019 Global Yields Will Remain Resilient In 2019 The fear of a global economic downturn appears greater than the current reality - a trend likely magnified by the ongoing U.S.-China trade tensions and the sharp fall in oil prices which some are interpreting to be a sign of weaker demand. BCA’s commodity strategists view the oil decline as purely supply driven, and expect that a tighter demand/supply balance will result in oil prices recovering recent losses and rising smartly in 2019. This should lead to a rebound in the inflation expectations component of global bond yields later next year (bottom panel). As was argued in the 2019 BCA Outlook, the conditions for a deep pullback in global growth are not yet in place, especially in the U.S. where consumer fundamentals remain solid (strong income growth, booming net worth and a low debt service ratio). China, where growth is currently slowing, remains the biggest wild card for the world economy, especially given the degree to which emerging market economies are levered to Chinese growth. Yet the most likely outcome is that Chinese authorities will make enough policy adjustments to stabilize the economy in the first half of 2019, which will help put a floor under global growth. With over 80% of OECD economies now with an unemployment rate below estimates of “full employment”, the backdrop today is more conducive to sustained higher inflation than at any point since the 2008 Global Financial Crisis (Chart 3). This means that actual inflation readings are likely to be stickier to the upside, especially for domestically focused measures like wages and services which are accelerating in many countries. Chart 3Tight Labor Markets Will Prevent A Sharp Drop In Inflation Tight Labor Markets Will Prevent A Sharp Drop In Inflation Tight Labor Markets Will Prevent A Sharp Drop In Inflation From the point of view of global central bankers, this means that as long as global growth does not slow sustainably below trend, then unemployment rates are unlikely to begin to rise. For policymakers who slavishly follow the Phillips Curve when forecasting inflation, that will make it difficult to shift to a more dovish policy bias, even if inflation remains below target for a time thanks to the recent pullback in oil prices (Chart 4). Chart 4Central Banks Who Believe In The Phillips Curve Can’t Turn Dovish 2019 Key Views: Normalization Is The "New Normal" 2019 Key Views: Normalization Is The "New Normal" The degree of policy bias in 2019 will not be uniform, though, which was also the case in 2018. Central banks in countries with core inflation rates closer to policymaker targets (the U.S., Canada, the U.K. if the Brexit uncertainty fades, Sweden) will be more likely to raise rates than those where inflation is still well below target (Japan, the euro area, Australia). Relative government bond market performance over the course of 2019 should reflect those trends. U.S. Treasury yields will still most likely to see the largest increase from current levels as the Fed will lift rates over the full 2019 calendar by more than markets are currently discounting (only 33bps are currently priced in the U.S. Overnight Index Swap curve – a low hurdle to beat). Key View #2: The Unwind Of Crisis-Era Global Monetary Policies Will Continue Quantitative easing (QE) – central banks buying huge amounts of bonds to help keep yields low enough to sustain economic growth amid weak inflation expectations – has been a dominant feature of global bond markets since the 2009 recession. Policymakers have been forced to engage in such unusual activities to try and boost weak inflation expectations even after policy interest rates have been cut to 0% (and even lower in some cases). Now, a decade later, inflation expectations are more stable and much closer to central bank targets in most countries (except, as always, Japan). That means government bond returns are no longer negatively correlated to equity returns (Chart 5), reducing the value of bonds as a hedge to stocks. Chart 5Bonds Are A Less-Effective Hedge For Equities With More Stable Inflation Bonds Are A Less-Effective Hedge For Equities With More Stable Inflation Bonds Are A Less-Effective Hedge For Equities With More Stable Inflation In the 2019 BCA Outlook, several other reasons were given as to why that correlation has been weakening, including a shift towards more consumption and less savings from aging populations entering their retirement years. The biggest change, however, has been the move from QE to “QT” (quantitative tightening) as central banks buy fewer bonds or, in the case of the U.S. Fed, actually letting bonds run of its massive balance sheet. The new year will bring an end to the net new buying phase of the European Central Bank (ECB) Asset Purchase Program. That represents a loss of €180 billion of liquidity into European bond markets compared to 2018 (twelve months at €15bn per month), both for government debt and investment grade corporates which are also part of the ECB’s program. This will come on top of reduced purchases from the Bank of Japan (BoJ), who will likely buy at a reduced ¥30 trillion pace in 2019 (down from around ¥40 trillion in 2018), and from the Fed who will let $600bn of maturing bonds run off its balance sheet ($360bn of which will be Treasuries). That slowing pace of central bank asset accumulation means that private investors must absorb an even greater supply of government bonds next year. The BCA Outlook estimated that the change in the supply of government bonds available to private investors would equal $1.2 trillion in 2019, a huge increase from the $400bn seen in 2018 (Chart 6). This will come at a time when new government bond issuance is set to increase once again thanks to wider U.S. budget deficits, further worsening the global supply/demand balance for government debt from the major developed economies. Chart 6Private Sector To Absorb More Bonds Private Sector To Absorb More Bonds Private Sector To Absorb More Bonds The reduction in the pace of central bank bond buying will continue to put gentle upward pressure on government bond yields, as has been the case since the pace of ECB purchases peaked in 2016 (Chart 7). More importantly, the diminished central bank liquidity expansion means there will be less money going into risky assets via the portfolio balance channel (i.e. private investors taking the funds earned from selling bonds to central banks and placing that in equity and credit markets). Chart 7Upward Pressure On Yields & Vol From 'QT' Upward Pressure On Yields & Vol From 'QT' Upward Pressure On Yields & Vol From 'QT' This creates a backdrop where volatility spikes will be more frequent, as has been the case in 2018 (bottom panel). Risky asset valuations will also be impacted from reduced inflows from yield-seeking investors who have sold government bonds to central banks. This suggests wider credit spreads and lower equity price/earnings multiples, all else equal (Chart 8). Chart 8Risk Asset Valuations Will Continue To Suffer From QT In 2019 Risk Asset Valuations Will Continue To Suffer From QT In 2019 Risk Asset Valuations Will Continue To Suffer From QT In 2019 Of course, all is not equal. A rebound in global growth could trigger a new wave of inflows into global equity and credit markets with valuations having cheapened in recent months. The important point is that, without central bank liquidity propping up asset prices, global risk assets will trade more off fundamentals in 2019 than has been the case during the past couple of years. Key View #3: Too Soon To Worry About Inverted Yield Curves “Yield curve inversions lead to recessions” is a well-known (if not well understood) relationship that has gained almost mythical status among investors. As the widely-watched spread between 2-year and 10-year U.S. Treasury yields (the 2/10 curve) has melted away during the course of 2018 – now sitting at a mere 13bps – the prognosticating power of the curve has many worried that a U.S. recession could be just around the corner. Especially after the Fed has raised the fed funds rate by 200 basis points over the past three years. Those fears are misguided, for several reasons: 1. The Treasury curve segment with the most successful track record in heralding U.S. recessions is the spread between the 10-year U.S. Treasury bond yield and the 3-month U.S. Treasury bill rate (Chart 9). That spread is still a firmly positive 42bps. We showed in a Special Report published last July that, on average, the length of time between the inversion of the 3-month/10-year Treasury curve and the beginning of a recession is seventeen months.2 Chart 9UST Curve Not Close To A True Recessionary Inversion Signal UST Curve Not Close To A True Recessionary Inversion Signal UST Curve Not Close To A True Recessionary Inversion Signal 2. The slope of the Treasury curve is unusually flat given the level of the fed funds rate measured in real (inflation-adjusted) terms. The previous three episodes where the 2-year/10-year Treasury curve has inverted over the past thirty years have occurred when the real fed funds rate was between 300-400bps (Chart 10). The current level of the real funds rate (deflated by headline CPI inflation) is near zero which, in the past, has occurred alongside a 2-year/10-year Treasury curve that had a positive slope between 150-200bps. Chart 10Global Yield Curves Look Too Flat Vs Real Policy Rates... Global Yield Curves Look Too Flat Vs Real Policy Rates... Global Yield Curves Look Too Flat Vs Real Policy Rates... 3. The depressed level of bond term premia is weighing on longer-dated Treasury yields and dampening the slope of the curve. This is happening not only in the U.S., but also in other major bond markets in Germany, the U.K. and Japan (Chart 11). The impact of global QE programs is the most likely common factor. Chart 11...With Global Term Premia Depressed ...With Global Term Premia Depressed ...With Global Term Premia Depressed 4. The 2-year/10-year U.S. Treasury curve has never been inverted without the real fed funds rate being above the neutral real rate, also known as R-star (Chart 12). Chart 12No 2/10 UST Inversion Before Real Rates Exceed R* No 2/10 UST Inversion Before Real Rates Exceed R* No 2/10 UST Inversion Before Real Rates Exceed R* The implication for fixed income investing for 2019 is that it is too soon in the Fed’s monetary tightening cycle to expect an inverted yield curve driven by an overly tight monetary policy. That outcome is more likely by late 2019 after inflation expectations pick up and the Fed delivers at least another 75bps over the course of the year, pushing the funds rate into restrictive territory. Key View #4: Poor Corporate Returns From The Aging Credit Cycle The other major fixed income implication of the 2019 BCA Outlook is that global corporate bond markets are likely to see another year of poor returns (both in absolute terms and relative to government bonds). Spreads remain near historically tight levels across most spread product sectors, suggesting that credit risk premia will need to be repriced higher as the endgame of the multi-year credit cycle draws nearer (Chart 13). Both investors and policymakers have grown increasingly worried about the risks to the U.S. corporate bond market from high corporate leverage. However, as was discussed in the Outlook, U.S. corporate interest coverage remains well above levels that have preceded the end of previous credit cycles and BCA’s models suggest U.S. corporate profit growth will remain solid (albeit much slower than the rapid +20% growth seen in 2018). Chart 13Fading Support For Corporate Bonds From Growth & Policy Fading Support For Corporate Bonds From Growth & Policy Fading Support For Corporate Bonds From Growth & Policy That does not mean that corporate bonds are without risk. With 50% of global investment grade bond indices now rated BBB (one notch above junk), the greater threat to corporates may come from downgrades. While those are less likely in a growing economy, investors in lower-rated investment grade bonds may require higher yields and spreads to compensate for the future risk of losses as those bonds could become “fallen angel” high-yield debt in the next economic downturn. This impact would be magnified as how many large fixed income managers have mandates that forbid investment in bonds rated below investment grade, thus creating forced selling in the event of downgrades. More fundamentally, the outlook for global corporate bonds, with spreads still much closer to historical tights than long-run averages, remains reliant on strong economic growth momentum and supportive monetary policy. On the former, we do not anticipate a move to sub-trend global growth, as discussed earlier, and corporate bond returns could stabilize once the current downtrend in the world economy subsides (Chart 14). This would likely represent a final period of calm, however. Tightening global monetary policies – both Fed hikes and diminished asset purchases – will create a more bearish backdrop for credit in the latter half of 2019 as markets begin to discount slower economic growth in 2020. Chart 14Fading Support For Corporate Bonds From Growth & Policy Fading Support For Corporate Bonds From Growth & Policy Fading Support For Corporate Bonds From Growth & Policy   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see the December 2018 edition of The Bank Credit Analyst, “Outlook 2019 – Late Cycle Turbulence”, available at bca.bcaresearch.com and gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31st 2018, available at gfis.bcaresearch.com.   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2019 Key Views: Normalization Is The "New Normal" 2019 Key Views: Normalization Is The "New Normal" Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Below-Benchmark Duration: Below-benchmark duration positions will continue to pay off in 2019 as the Fed delivers more than the 32 bps of rate hikes that are priced into the curve for the next 12 months. While tighter financial conditions will probably necessitate a pause in the Fed’s gradual rate hike cycle at some point next year, this is already more than discounted in current market prices. A further deterioration in housing starts and new home sales, or a significant uptick in initial jobless claims would call our below-benchmark duration view into question. Neutral Corporate Credit: In an environment where the yield curve is quite flat but still positively sloped, excess returns to corporate bonds also tend to be quite low, but still positive on average. Investors should be looking for low, but positive, excess returns from credit on a 12-month investment horizon. However, credit spreads will probably widen further in the near-term and then tighten once the Fed signals a pause and global growth improves. Overweight Munis and Local Authorities: Tax-exempt municipal bond yields are very attractive relative to corporate bonds and both municipal and Local Authority bonds are relatively insulated from the weakness in global growth that will threaten the corporate profit outlook in the coming quarters. Both of these sectors should perform well in 2019. Overweight TIPS: Long-maturity TIPS breakeven inflation rates have shifted down in recent weeks, but will move higher in 2019, eventually stabilizing in a range between 2.3% and 2.5%. The rebound in oil prices that our commodity strategists expect will help, but TIPS outperformance will largely be driven by investor expectations slowly adapting to the new reality that inflation will remain much closer to the Fed’s target than it has in recent years. Yield Curve Inversion In Late 2019: Below-target TIPS breakeven inflation rates and an inverted yield curve cannot coexist. As such, investors should not worry about a sustained inversion of the yield curve until later in 2019. To profit from this view, investors should position for steepeners at the front-end of the curve. We recommend going long the 2-year bullet and short a duration-matched 1/5 barbell. The belly (5-7 year) part of the curve has become very expensive and should be avoided at all costs. Feature BCA published its 2019 Outlook two weeks ago.1 That report lays out the macroeconomic themes that our strategists think will drive markets next year. In this Special Report, we specify how investors should implement those views in the context of a U.S. bond portfolio. Key Views The main conclusions from the 2019 Outlook are: Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. […] that means capacity pressures will intensify, causing inflation to move higher. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. […] Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. In the verbiage of monetary policymakers, the BCA view is that U.S. interest rates remain below the neutral level that is consistent with trend GDP growth and stable inflation. This means that the Fed’s rate hike cycle will continue in 2019, and that monetary policy will not turn restrictive until later in the year. It is this view of U.S. interest rates remaining below neutral until late 2019 that drives our portfolio recommendations. Key Risks Given our main premise, the biggest risk to our recommended portfolio allocation is that interest rates move above neutral sooner than we anticipate. We will be monitoring three main risks in the coming months to help us decide whether our main premise needs to be re-evaluated. Risk #1: Housing Since a large amount of leverage is employed in the acquisition of new homes, there is good reason to believe that housing is the main channel through which interest rates impact the real economy. This is validated by the empirical data which show that residential investment, housing starts and new home sales all provide a good indication of when monetary policy turns restrictive and of when Treasury yields peak for the cycle.2 With that in mind, the housing data have clearly deteriorated during the past 6-9 months. However, with the 12-month moving averages of housing starts and new home sales still trending higher, it is too soon to say that housing has peaked for the cycle (Chart 1). Our sense is that the recent deterioration is a result of the sharp move higher in mortgage rates that occurred earlier this year. Now that rates have moderated, the housing data should improve.3 Chart 1The Housing Market Predicts Recessions The Housing Market Predicts Recessions The Housing Market Predicts Recessions A decisive breakdown in the 12-month moving averages of housing starts and new home sales would cause us to question our premise that U.S. interest rates remain below neutral. Risk #2: Jobless Claims With the unemployment rate at 3.7%, the U.S. labor market is in rude health. That being said, a move higher in the unemployment rate would be a clear sign that monetary policy is restrictive and that a recession is right around the corner. In the post-war era, there has never been a case where the 3-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession taking place. Often, a turn higher in the unemployment rate is preceded by an increase in initial jobless claims, and the 4-week moving average in claims has increased for four consecutive weeks (Chart 2). So far, that increase is no cause for concern. Historically, the 6-month change in jobless claims needs to reach +75k before a recession occurs (Chart 2, bottom panel). Nevertheless, the recent upturn in claims will bear monitoring in the months ahead. Chart 2Initial Jobless Claims Are Worth Monitoring Initial Jobless Claims Are Worth Monitoring Initial Jobless Claims Are Worth Monitoring Risk #3: Weak Foreign Growth & A Strong Dollar It is a bit misleading for us to include weak foreign growth and a strong dollar in the “key risks” section. In fact, our base case outlook involves weak foreign economic growth migrating to the U.S. via a stronger dollar and leading to a mild slowdown in U.S. economic activity during the next few quarters (Chart 3).4 This will probably even cause the Fed to pause its gradual rate hike cycle, but will not bring it to an end. This report also contains our recommendations for how to tactically position for this pause. Chart 3Weak Global Growth Will Drag The U.S. Lower Weak Global Growth Will Drag The U.S. Lower Weak Global Growth Will Drag The U.S. Lower The Awkward Middle Phase When constructing U.S. bond portfolios on a cyclical (6-12 month) investment horizon, we find it useful to split the economic cycle into phases based on the slope of the yield curve. Our economic view informs what phase (or phases) of the cycle will reign during the next 6-12 months, and the phase of the cycle informs our investment posture. We define three phases of the cycle as follows (Chart 4): Chart 4The Three Phases Of The Cycle The Three Phases Of The Cycle The Three Phases Of The Cycle Phase 1: From the end of the prior recession until the 3-year/10-year Treasury slope flattens to below 50 bps. Phase 2: When the 3-year/10-year Treasury slope is between 0 bps and +50 bps. Phase 3: From when the 3-year/10-year Treasury curve inverts until the start of the next recession.5 Table 1 shows how each U.S. fixed income asset class has performed in each phase. We use excess returns from the Bloomberg Barclays Treasury index versus cash to track the returns earned from taking portfolio duration risk. For other fixed income sectors we display excess returns versus duration-matched Treasuries. We also include the performance of the S&P 500 versus the Bloomberg Barclays Treasury index. Table 1Risk Asset Performance In Different Yield Curve Regimes 2019 Key Views: Implications For U.S. Fixed Income 2019 Key Views: Implications For U.S. Fixed Income As should be clear from the macro view discussed above, we believe that we will remain in Phase 2 of the cycle for the bulk of 2019. With the 3/10 Treasury slope a mere 13 bps at present, temporary curve inversions might occur earlier in the year, but they will not be sustained (see Key View #5 below). The first implication of being in Phase 2 is that corporate bond excess returns (both investment grade and high-yield) are likely to be positive on average, but will be very low. The bulk of corporate bond excess returns are earned in Phase 1 of the cycle when the yield curve is very steep. Excess returns don’t turn decisively negative until after the curve inverts and we enter Phase 3. Like corporate credit, Treasury excess returns are also lower in Phase 2 than in Phase 1. This makes Phase 2 an awkward one for portfolio positioning. The expected return from taking an extra unit of credit risk is quite low, as is the expected return from taking an extra unit of duration risk. In fact, cash tends to be one of the best performing asset classes in Phase 2. The excess returns from most other spread products present a similar pattern to those from corporate bonds. Elevated excess returns in Phase 1, much lower – though typically still positive – excess returns in Phase 2, negative excess returns in Phase 3. One exception to this pattern is tax-exempt municipal debt which, outside of the mid-1990s cycle, has performed similarly or better in Phase 2 than it has in Phase 1. Domestic Agency bonds and Supranationals also stick out as being very defensive sectors. They both almost always provide a small positive excess return versus Treasuries, but never provide a large reward. In the remainder of this report we discuss the five key implications for U.S. bond portfolio positioning that follow from remaining in Phase 2 of the cycle for most of 2019. Key View #1: Below-Benchmark Duration We think below-benchmark portfolio duration positions will continue to pay off in 2019. We have already shown that Phase 2 of the cycle tends to coincide with relatively low excess Treasury returns, but the slope of the yield curve is not the best indicator for Treasury returns versus cash. For that, we turn to our Golden Rule of Bond Investing which says that Treasuries tend to underperform (outperform) cash on a 12-month investment horizon when the Fed delivers more (fewer) rate hikes than what was discounted at the beginning of the 12-month period (Chart 5).6 Chart 5The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for only 32 bps of rate hikes during the next 12 months. More specifically, the market is pricing-in a rate increase this month, followed by one more in 2019 and then rate cuts in 2020 (Chart 6). Chart 6Market's Rate Expectations Are Too Low Market's Rate Expectations Are Too Low Market's Rate Expectations Are Too Low This extremely depressed market pricing makes us reluctant to increase duration, even tactically. While we do expect U.S. growth to slow during the next few quarters, probably by enough to necessitate a pause in the Fed’s tightening cycle, this pause is already more than reflected in current market prices. Key View #2: Neutral Corporate Credit Cyclical Horizon (6-12 Months) Being in Phase 2 of the cycle warrants a relatively defensive posture toward credit risk. For now, we recommend a neutral allocation to corporate bonds with an up-in-quality bias. We will further reduce exposure to underweight when we transition to Phase 3 of the cycle, likely late in 2019. We also recommend looking at the long-end of the credit curve to increase the average spread of your portfolio.7 Table 2 makes the importance of correctly identifying the phase of the cycle even more apparent. It shows the excess returns to both investment grade and high-yield corporate bonds for different investment horizons directly after the 3/10 Treasury slope flattens into a given range. For example, the median excess return to investment grade corporate bonds in the 12 months after the 3/10 slope breaks below 25 bps is -1.02%. Table 2Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) 2019 Key Views: Implications For U.S. Fixed Income 2019 Key Views: Implications For U.S. Fixed Income As in Table 1, Table 2 shows that excess returns are much higher when the yield curve is steep and that they tend to turn negative after the curve inverts. But unlike the results in Table 1, the analysis in Table 2 includes recessionary periods and makes no attempt to split the cycle into different phases. It is a purely forward looking rule that calculates excess returns after different “trigger points” are reached. For example, the 12-month median excess return of -1.02% after the 3/10 slope breaks below 25 bps is biased downward because of periods when the slope broke below 25 bps and then continued to flatten until it inverted. An environment where the slope stayed range-bound between 0 bps and +25 bps for an extended period – closer to what we expect in 2019 – will deliver somewhat better excess returns. Tactical Horizon (< 6 Months) The phase of the cycle helps us specify our excess return expectations for the next 12 months, and based on our outlook, we expect excess returns will be positive, but close to zero. However, as we write this report, corporate spreads are widening at a fairly rapid clip. We expect the carnage will continue in the near-term, but are monitoring catalysts to initiate a tactical overweight recommendation on corporate credit.8 As they were in 2015, corporate spreads are widening at the moment due to the toxic combination of slowing global growth and relatively hawkish monetary policy. We expect that sometime in early 2019, Fed policy will ease at the margin and this will coincide with a near-term peak in credit spreads and a period of improved global growth. To determine when spreads peak we are monitoring several indicators of global growth and Fed policy that successfully called the last peak in early-2016. On the global growth side, the key indicators are (Chart 7A): The CRB Raw Industrials Index The BCA Market-Based China Growth Indicator9 The price of global industrial mining stocks On the monetary policy front, the key indicators are (Chart 7B): The 12-month Fed Funds Discounter The gold price The trade-weighted dollar Chart 7AKey Indicators: Global Growth Key Indicators: Global Growth Key Indicators: Global Growth Chart 7BKey Indicators: Monetary Policy Key Indicators: Monetary Policy Key Indicators: Monetary Policy All in all, our conviction that we will remain in Phase 2 of the cycle for most of 2019 suggests we should maintain a neutral allocation to corporate bonds on a 6-12 month investment horizon, looking for small positive excess returns. In the near-term, we expect spreads will continue to widen in the next few weeks, but will peak once the Fed signals a pause in its rate hike cycle and global growth indicators show some improvement. We are monitoring several catalysts that will help us decide when to initiate a tactical overweight position in corporate bonds. Key View #3: Overweight Munis And Local Authorities The analysis in Table 1 showed that tax-exempt municipal bonds often provide strong excess returns in Phase 2 of the cycle. This makes them an attractive place to position in the current environment, especially given the relative attractiveness of muni yields. Table 3 shows that the average yield on the Bloomberg Barclays Municipal Index is 2.75%. If we assume even a 30% effective tax rate, the taxable-equivalent yield becomes 3.93%, well above the average yield offered by the Aa-rated Corporate index. Table 3Municipals Are Attractive 2019 Key Views: Implications For U.S. Fixed Income 2019 Key Views: Implications For U.S. Fixed Income Another reason to like munis in the current cycle is that state & local government revenues are relatively insulated from weakness in the global economy. As foreign growth weakens and drives up the dollar, corporate profits will suffer much more than state & local government tax revenues. A similar case can be made for the Local Authority sub-index of the Bloomberg Barclays Aggregate. This index is comprised largely of taxable municipal debt (and some Canadian provincial debt), and while the average yield is lower than for tax-exempt munis, it is still competitive compared to corporate bonds. But most importantly, the sector is relatively insulated from weak foreign growth and a strong dollar. Municipal bonds and the Local Authority sub-index are important overweights in our recommended portfolio as we head into 2019. Key View #4: Overweight TIPS Versus Nominal Treasuries Though long-maturity TIPS breakeven inflation rates have fallen in recent weeks, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. We believe that both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates will reach our target range of 2.3% to 2.5% in 2019. At present, TIPS breakevens are caught between being pulled down by weakening global growth and pushed up by mounting U.S. inflationary pressures (Chart 8). Most recently, weaker global growth has been winning and breakevens have moved lower alongside the plunge in oil prices. Chart 8TIPS Breakevens Face Opposing Forces TIPS Breakevens Face Opposing Forces TIPS Breakevens Face Opposing Forces Taking a step back, it is very unlikely that global growth and commodity prices will continue to fall at their current rates throughout 2019. At some point, a dovish turn from the Fed will lead to some depreciation of the dollar and global growth will stage a rebound. Our commodity strategists also expect a rebound in the oil price. They target an average of $82/bbl for Brent crude oil in 2019.10 In the meantime, core U.S. inflation will continue to print close to the Fed’s 2% target, and maybe even a bit higher in late 2019. At some point, inflation expectations will need to adapt to the new reality of inflation being near the Fed’s target. Historically, this suggests a range of 2.3% to 2.5% for TIPS breakeven inflation rates. Inflation expectations can be slow to adapt to a changing environment, and after several years of the Fed missing its inflation target from below, many investors remain trapped in a deflationary mindset. To get an idea of how long it takes inflation expectations to adjust to changes in the economy, we use our Adaptive Expectations Model of TIPS breakevens (Chart 9).11 The model is based on three factors: Chart 9The Adaptive Expectations Model Of The 10-Year Breakeven Rate The Adaptive Expectations Model Of The 10-Year Breakeven Rate The Adaptive Expectations Model Of The 10-Year Breakeven Rate The 12-month rate of change in headline CPI The New York Fed’s Underlying Inflation Gauge The 120-month rate of change in core CPI Of the three factors, the 120-month rate of change in core CPI carries the largest weight in the model. In other words, the catalyst for moving TIPS breakeven rates higher will simply be core U.S. inflation continuing to print near the Fed’s target for a prolonged period of time. All in all, investors should maintain overweight allocations to TIPS versus nominal Treasuries in 2019, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. The current slowdown in global growth and commodity prices will not last for the entire year, and U.S. inflationary pressures will continue to mount as the U.S. economy grows at an above-trend pace with a very tight labor market. Key View #5: No Yield Curve Inversion Until Late 2019 The final key view that falls out of our main macro premise, which is that the fed funds rate will remain below neutral for the bulk of 2019, is that the yield curve will not sustainably invert until late 2019. This is also probably the most contentious of our key views, given recent market moves. The main reason why we think the slope of the yield curve will remain quite flat, but positive, for most of 2019 is that sustainable yield curve inversion cannot coexist with below-target TIPS breakeven inflation rates. An inverted yield curve is a signal that the market views monetary policy as overly restrictive. It means that investors expect U.S. growth and inflation to fall in the future, necessitating rate cuts. However, long-maturity TIPS breakeven inflation rates below the 2.3% - 2.5% range that has historically been consistent with well-anchored inflation expectations signal that the market believes that inflation will not sustainably return to the Fed’s target. In other words, for an inverted yield curve and below-target TIPS breakeven inflation rates to coexist, we would have to believe that the Fed would tighten monetary policy into restrictive territory without sufficient inflationary pressures to meet its target. It is difficult to envision the Fed committing such an egregious policy error. In the event that the yield curve does invert while TIPS breakevens are below target, it is much more likely that either the Fed will adopt a more  dovish policy stance, leading to a bull-steepening of the curve; or, inflation will rise leading to higher TIPS breakevens and causing the curve to bear-steepen. In either scenario, it is hard to see how yield curve inversion will last very long without significantly higher TIPS breakevens. We will call an end to Phase 2 of the cycle only when the yield curve is inverted and long-maturity TIPS breakeven inflation rates are above 2.3%. Curve Positioning As for how to position on the yield curve in 2019, the biggest change since the end of last year is that the belly (5-7 year) of the curve is now very expensive (Chart 10). In fact, the 2/5 slope is slightly inverted as we go to press, meaning there is actually negative rolldown in the 5-year note. Chart 10Par Coupon Treasury Curve 2019 Key Views: Implications For U.S. Fixed Income 2019 Key Views: Implications For U.S. Fixed Income By far, the best place to position on the curve is the 2-year maturity point.12 Our model of the 1/2/5 butterfly spread (2-year bullet over duration-matched 1/5 barbell) shows that the 2-year is cheap relative to the 1/5 slope. Conversely, our model of the 2/5/10 butterfly spread shows that the 5-year bullet has become expensive relative to the 2/10 slope (Chart 11). Chart 11Favor The 2-Year Bullet Favor The 2-Year Bullet Favor The 2-Year Bullet Butterfly trades where you favor the bullet maturity versus the barbell perform well when the curve steepens. For example, the 2-year tends to outperform the 1/5 barbell when the 1/5 slope steepens. At present, the cheapness of the 2-year suggests that the butterfly spread is priced for significant 1/5 flattening in the coming months. Even stability in the 1/5 slope will cause the 2-year to outperform, and our key yield curve recommendation at the moment is to go long the 2-year bullet and short a duration-matched 1/5 barbell.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1  Please see The Bank Credit Analyst, "OUTLOOK 2019: Late-Cycle Turbulence”, dated November 27, 2018, available at bca.bcaresearch.com 2  Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 5 We use the 3-year/10-year Treasury slope because it closely approximates the 2-year/10-year slope, but with more back-data. 6 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “What Kind Of Correction Is This?”, dated October 30, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 9 A combination of 17 different financial market variables that are highly levered to Chinese growth. Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 10 Please see Commodity & Energy Strategy Weekly Report, “The Third Man At OPEC 2.0’s Meeting”, dated November 29, 2018, available at ces.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, “The Sweet Spot On The Yield Curve”, dated November 13, 2018, available at usbs.bcaresearch.com

Highlights Our take on the key macro drivers of financial markets hasn’t evolved much since we laid it out this summer, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... but the inflection points are getting nearer: The good times won’t last forever, though. The Fed is resolutely tightening policy, BBB-heavy investment-grade issuance has the corporate bond market flirting with a plague of fallen angels, and the global economy is slowing. Our strategy remains more cautious than our outlook for now, … : Although we think the equity bull market has another year to run, and the expansion will stretch into 2020, we are only equal-weight equities, while underweighting bonds and overweighting cash. … but we’re alert to opportunities to get more aggressive: Investment-grade and high-yield bonds are unlikely to offer an attractive risk-reward profile, but the S&P 500 shouldn’t decline much more if the economy holds up. Feature Mr. and Ms. X’s annual visit is an occasion for every BCA service to look toward the coming year, mindful of how it could improve on the one just past. The theme we settled on in last year’s discussion, Policy and Markets on a Collision Course, began asserting itself in earnest in October, and appears as it will be with us throughout 2019. The Fed is nearing its fourth rate hike this year, on the heels of three in 2017, and markets are warily contemplating the tipping point at which higher interest rates begin to interfere with activity. The yield curve has become a constant worry (Chart 1), with short rates moving in step with the fed funds rate while yields at the long end have been just one-half as sensitive (Chart 2). Chart 1Yield Curve Anxiety Has Exploded ... Yield Curve Anxiety Has Exploded ... Yield Curve Anxiety Has Exploded ...   Chart 2... As The Curve Has Steadily Flattened 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? Trade tensions are an even thornier policy challenge. After flitting on and off investors’ radar earlier in the year, trade barriers have been a major source of angst in recent months as central banks, investor polls and company managements increasingly cite them among their foremost concerns. Unfortunately, our geopolitical strategists do not expect relief any time soon. They see trade as just one aspect of an extended contest for supremacy between China and the U.S. Late-Cycle Turbulence, our 2019 house theme, pairs nicely with Policy-Market Collision. The gap between our terminal fed funds rate expectation and the money market’s is huge, and leaves ample room for a repricing of the entire yield curve. Trade has been a roller coaster, capable of inducing whiplash in 140 characters or less, and it may already have brought global manufacturing to the brink of a recession. Oil lost 30% in two months at the stroke of a pen; its immediate fate is in the hands of OPEC, but the caprice with which Iranian sanctions may or may not be re-imposed is likely to feed uncertainty. As we advised Mr. and Ms. X a few weeks ago, investors should stay nimble; there is no point to committing to a twelve-month strategy right now.1 The Fed Funds Rate Cycle Our equilibrium fed funds rate model estimates that the equilibrium fed funds rate, the rate that neither encourages nor discourages economic activity, is currently around 3%. It projects that the equilibrium rate will approach 3¼% by the middle of 2019, and 3⅜% by year end. The implication is that policy is comfortably accommodative now, and will not cross into restrictive territory for another 12 months – assuming that the Fed hikes four times next year, in line with our ambitious expectation. If the Fed steps back from its gradual pace, and only hikes three times in 2019 (as per the dots), or just once (as per the money market), the day when the economy and markets will have to confront tight monetary conditions will be pushed even further into the future. Stretching monetary accommodation until late next year would seem to forestall the arrival of the next recession until at least the first half of 2020. Tight policy is a necessary, if not sufficient, condition for a recession, as recessions have only occurred when the policy rate has exceeded our estimate of equilibrium over the six decades covered by our model. A longer stretch of accommodation would also continue to nourish the equity bull market and discourage allocations to Treasuries. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 1), while Treasuries have wilted, especially in the current phase of the fed funds rate cycle (Table 2). Table 1Equities Flourish When Policy’s Easy ... 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last?   Table 2... While Treasuries Stumble 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? The Business Cycle The state of policy is one of the three components in our simple recession indicator. Neither of the other two is sounding the alarm, either. Our preferred 3-month-to-10-year segment of the Treasury yield curve is still comfortably upward sloping, even if it has been steadily flattening and we expect it to invert late next year (Chart 3). Year-over-year growth in leading economic indicators decelerated slightly last month, but remains well above the zero line that has reliably preceded past recessions. Chart 3Flattening, But Not Yet Flat Flattening, But Not Yet Flat Flattening, But Not Yet Flat The Credit Cycle Anyone following the credit cycle would do well to start with the axiom that bad loans are made in good times. Its converse is just as true: good loans are made in bad times. Loan officers are every bit as susceptible to the recency bias as other human beings, and they tend to extrapolate from the freshest observations when assessing a borrower’s prospects. When things are good, lenders assume they will continue to be good, and let their guard down by lending to marginal borrowers and/or relaxing the terms on which they will lend. When things are bad, on the other hand, loans have to be underwritten so tightly that they squeak. The upshot is that lending standards and loan performance are tightly bound up with one another. In the near term, standards and performance are joined at the hip; over a five-year period, standards lead performance as a contrary indicator. Defaults almost certainly bottomed for the cycle in 2014, to judge by speculative-grade bonds (Chart 4, top panel), and loans (Chart 4, bottom panel). Standards reliably followed, and the proportion of lenders easing standards for corporate borrowers, as per the Fed’s senior loan officer survey, spiked (Chart 5). Chart 4Weakening, But Not Yet Weak Weakening, But Not Yet Weak Weakening, But Not Yet Weak   Chart 5Standards Follow Performance In Real Time ... Standards Follow Performance In Real Time ... Standards Follow Performance In Real Time ... The 2012 and 2014 peaks in willingness suggest that performance is due to erode (Chart 6). We do not foresee a step-function move higher in defaults, or a sudden collapse in loan availability, but we do expect some fraying at the edges. Given how tight spreads remain, any weakness at the margin could go a long way to wiping out much, if not all, of spread product’s excess return. The bottom line is that the credit cycle is well advanced, and investors should expect borrower performance and lender willingness to weaken from their current levels. Chart 6... And Lead Them Over The Intermediate Term ... And Lead Them Over The Intermediate Term ... And Lead Them Over The Intermediate Term Bonds We have written at length on our bearish view on rates and Treasuries.2 The key pillar supporting our rationale is the gap between our terminal fed funds rate estimate, 3.5-4%, and the market’s view that the Fed will not go beyond 2.75%, if indeed it gets to that level at all (Chart 7). The gap is big enough to drive a truck through, and leaves a lot of room for yields to shift higher all along the curve, even if the Fed were to slow its 25-bps-a-quarter tempo, as the Wall Street Journal suggested it might in a report last Thursday. We continue to believe that inflation is the inevitable outcome once surging aggregate demand collides with limited spare capacity, and that the Fed will be forced to push the fed funds rate to 3.5% and beyond. Chart 7Something's Gotta Give Something's Gotta Give Something's Gotta Give Our view that the credit cycle has already passed its peak drives our view on spread product. Though we remain constructive on the economy and the outlook for corporate earnings, we are not enamored of the risk-reward offered by corporate bonds. Although high-yield spreads blew out by nearly 125 bps from early October to late November, high yield still does not look cheap (Chart 8, bottom panel). The same holds for investment-grade spreads, which remain near the bottom of their long-term range despite widening by over 50 bps (Chart 8, top panel). Chart 8Spreads Are Still Tight Spreads Are Still Tight Spreads Are Still Tight Bottom Line: We recommend that investors underweight fixed income within balanced portfolios, while underweighting Treasuries and maintaining below-benchmark duration. We recommend benchmark holdings in spread product, but we expect to downgrade it to underweight before the end of the first half. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive for another twelve months or so, the bull market should have about another year to go. We downgraded equities to equal weight as a firm in mid-June nonetheless, on signs of global deceleration and the potentially malign effects of tariffs and other impediments to global trade. U.S. Investment Strategy fully supported that decision, but we are alert to opportunities to upgrade equities to overweight within U.S. portfolios if prices decline enough to make the prospect of a new cycle high attractive on a risk-reward basis. The risk-reward requirement implies that the fall in price would have to occur without a material weakening of the fundamental backdrop. For now, we think the fundamental supports remain stable, as per the equity downgrade checklist we constructed to keep tabs on them. The checklist monitors recession indicators, none of which betray any concern now; factors that may weigh on corporate earnings; inflation measures, because higher inflation could motivate the Fed to hike more quickly than planned, with adverse consequences for the bull market; and signs of overexuberance (Table 3). Table 3Equity Downgrade Checklist 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? The earnings-pressure section focuses on the key factors that might signal margin contraction – wage growth, dollar strength and rising bond yields – but none of them look especially problematic now. While we think compensation gains will eventually push the Fed to go beyond its own terminal rate estimates, they have not yet picked up enough to cause concern. The dollar has paused in its advance, mostly marking time since the end of October. Only BBB corporate yields have gotten closer to checking the box (Chart 9). BCA’s preferred margin proxies remain in good shape, on balance (Chart 10), and our EPS profit model is calling for robust profit growth across all of next year (Chart 11). Chart 9Higher Rates Will Exert Some Margin Pressure Higher Rates Will Exert Some Margin Pressure Higher Rates Will Exert Some Margin Pressure   Chart 10In The Absence Of Margin Pressures, ... In The Absence Of Margin Pressures, ... In The Absence Of Margin Pressures, ...   Chart 11... 2019 Earnings Could Hold Up Nicely ... 2019 Earnings Could Hold Up Nicely ... 2019 Earnings Could Hold Up Nicely Oil’s plunge has pulled both headline CPI and longer-run inflation expectations lower. Although we think that the inflation respite is merely a head fake, and that oil will soon regain its footing (please see below), the run of harmless inflation data has the potential to soothe some market concerns about the Fed. If the Fed itself takes the data at face value, it may signal that the current 25-bps-a-quarter gradual pace could be slowed. As for exuberance, the de-rating the S&P 500 has endured since its forward multiple peaked at 18.5 in January suggests that it’s not a problem. We are not living through anything remotely resembling an equity mania. Bottom Line: BCA’s mid-June downgrade of global equities from overweight to equal-weight was timely. We remain equal-weight in balanced U.S. portfolios, but are more likely to upgrade U.S. equities than downgrade them, given the supportive cyclical backdrop. Oil We devoted our report two weeks ago to the oil outlook and its implications for the economy. Our Commodity & Energy Strategy service’s bullish 2019 view has not changed: it still sees a market in a tight supply/demand balance with high potential for supply disruptions and a smaller-than-usual inventory reserve to make up the slack. The unexpected release of over a million barrels a day of Iranian output has played havoc with oil prices, but does not provoke the growth concerns that declining demand would. Provided OPEC is able to agree on production cuts, and abide by them going forward, our strategists see Brent and WTI averaging $82 and $76/barrel across 2019. The Dollar We remain bullish on the dollar, though it will find the going rougher than it did in 2018. Traders have built up sizable net long positions, so it will take more for the greenback to extend its advance than it did to begin it. Ultimately, we think desynchronization between the U.S. and the rest of the major DM economies will keep the dollar moving higher. If the U.S. does not continue to outgrow the currency-major economies by a healthy margin, and/or the Fed does not respond to that growth by hiking rates to prevent overheating, the dollar’s advance may be nearly played out. Putting It All Together Three major assumptions underpin our views: The U.S. economy is at risk of overheating in its second year of markedly above-trend growth fueled by fiscal stimulus, and the Fed will respond to that risk by decisively raising rates. There will be a noticeable global slowdown, but it will not go far enough to turn into a recession. The U.S. will remain mostly immune to the global slump. We will be positioned well if all of these assumptions are validated by events, though timing is always uncertain. Financial-market volatility often increases late in the cycle, and we expect the backdrop to remain fluid. We are trying to maintain a fluid mindset in kind, monitoring the incoming data to make sure our cyclical assessments still apply, while remaining alert to opportunities created by significant price swings. Although we are neither traders nor tacticians, we want to retain some flexibility, and are trying to resist mentally locking in our positioning for the entire year. We are particularly focused on the monetary policy backdrop and the transition from accommodative to restrictive policy, which has historically been critically important for asset allocation. Our main goal is to anticipate the approach of inflection points in the key cycles – business, credit and monetary – as adeptly as we can. We are also resolved to look through the noise of one-off price swings and the blather that has already been clogging the airwaves. We seek to help our clients formulate a strategy for navigating the turbulence without being swept up in it. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the December 2018 Bank Credit Analyst, “Outlook 2019: Late-Cycle Turbulence,” available at www.bcaresearch.com. 2 Please see the July 30, 2018 U.S. Investment Strategy, “The Rates Outlook,” the September 17, 2018; U.S. Investment Strategy, “What Would It Take To Change Our Bearish Rates View?” and the November 5, 2018; U.S. Investment Strategy, “Checking In On Our Rates View,” available at usis.bcaresearch.com.

Highlights The Reserve Bank of Australia (RBA) may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band.  Reflation in China could also embolden the RBA to tighten monetary policy – though the odds of a more aggressive stimulus package will decline as long as China’s overall economy remains stable and the U.S. maintains its tariff ceasefire. The Labor Party is favored to win the federal election, which is most likely to occur in May. This is a low-conviction view, as polls are tight and economic improvement will help the ruling Liberal-National Coalition. Feature 2018 has been a challenging year for global financial markets, as investors have had to deal with greater economic uncertainty, less dovish central banks and more volatile asset prices. One country that has bucked the trend to some degree is Australia. The nation has famously avoided a recession since 1991 and last saw a tightening of monetary policy in 2010. While the recession streak is unlikely to be broken in 2019, there are growing risks that the era of interest rate tranquility will soon end. In this Special Report, jointly published with our colleagues at BCA Geopolitical Strategy, we update our views on Australia for 2019 – a year when the investment backdrop has the potential to become far more interesting, and volatile, due to election year uncertainty and a potential shift to a more hawkish bias for monetary policy. The Bond Outlook: What To Watch To Turn Bearish BCA Global Fixed Income Strategy has maintained an overweight stance on Australian government bonds since the end of 2017. That high-conviction view stemmed from our expectation that the Reserve Bank of Australia (RBA) would keep policy rates on hold for longer due to sluggish economic growth and underwhelming inflation. This recommendation has performed well, with Australian government bonds returning 2.4% (currency-hedged into U.S. dollars) in 2018 year-to-date, beating the Bloomberg Barclays Global Treasury index by 190bps. The benchmark 10-year Australian government is now yielding 36bps below the equivalent 10-year U.S. Treasury yield, the tightest spread since 1980 (Chart 1). Chart 1Australian Bonds Have Outperformed Australian Bonds Have Outperformed Australian Bonds Have Outperformed Looking ahead, we still have a positive opinion on Australian debt relative to its global peers over the next six months. The RBA is unlikely to make any adjustments to the Cash Rate - which remains at a highly-accommodative level of 1.5% - without seeing some signs of accelerating inflation in both the Q4 2018 and Q1 2019 CPI reports. This is especially true given the political uncertainty with another federal election due by May 18,1 which could change the outlook for fiscal policy (as we discuss later in this report) and impact the RBA’s economic projections. In our view, the RBA will only be able to seriously consider an interest rate hike, warranting a downgrade of our recommended overweight stance, if all three of the following conditions occur: Australia’s underemployment rate falls below 8% China’s economy shows convincing evidence of reacceleration, especially in commodity-intensive industries like construction Core CPI inflation rises back to at least the midpoint of the RBA’s 2-3% target band We will now discuss each of these in turn. Underemployment Australia is a fairly open economy with a large export sector, but consumer spending is still the largest share of GDP (60%) so it matters most for growth. On that front, real consumption has grown in a narrow and uninspiring range between 2-3% over the past five years. Anemic wages and disposable incomes have been the problem, with the growth of both (in nominal terms) struggling to grow faster than low realized inflation, which now sits below the RBA’s inflation target range of 2-3% (Chart 2). Households have been forced to deploy a greater share of that modest income growth just to maintain spending, with the savings rate plunging from 8% at the end of 2014 to 1% this year and consumer debt piling up. Chart 2An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending The dynamics may be changing in a more positive direction, however. Growth rates of nominal wage (+2.3%) and disposable income (+3.1%) have accelerated this year to a pace faster than inflation. With real incomes perking up, the year-over-year growth rate of real consumer spending growth accelerated to 3% in Q3/2018, driving real GDP growth to similar levels. A sustained pickup in wage growth is necessary before the RBA would even contemplate a rate hike. For that to occur, there must be decisive evidence of a tightening Australian labor market and increased resource utilization. While the headline unemployment rate of 5.0% is below the OECD’s estimate of the full employment NAIRU for Australia (5.3%), broader measures of labor market slack are still at elevated levels. Specifically, the “underemployment” rate, which includes workers who are working fewer hours than they would like or at jobs below their skill levels, is still at an elevated 8.3% (Chart 3). That is down from the peak of just below 9% seen in early 2017, but well above the 2012 trough near 7% (when wage growth was close to 4%).  Chart 3UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages Australian wage growth tends to correlate more with the underemployment rate than the traditional unemployment rate (middle panel). This suggests that the recent blip higher in wage growth could be the beginning of a new trend, given that it has occurred alongside the recent drop in underemployment. Already, underemployment is back below the levels that prevailed when the RBA did its last interest rate cut back in 2016 (bottom panel).  A further dip lower in the underemployment rate to below the 8% threshold would likely confirm that wage growth has more upside. That outcome would give the RBA greater confidence that consumer spending will gain more strength even with a low savings rate, and that CPI inflation will return back into the target range – both outcomes that would justify some removal of the RBA’s highly stimulative monetary accommodation. China Stimulus The main connection from China’s economy to Australia is through Chinese demand for Australian exports. There is also an indirect, but very important, link between Chinese demand boosting industrial commodity prices. The latter boosts Australian growth through positive terms-of-trade effects and increased capital spending in commodity-related sectors like mining. Iron ore is the most important of those commodities, representing 18% of total Australian goods exports, with 85% of those iron ore exports going to China. Australian export growth has decelerated during 2018 from the very robust 15% year-over-year pace to a still solid 10% rate. This has mirrored the trends seen in many other economies, where exports have slowed alongside diminished demand from China. If Chinese authorities change their current policy trajectory, and embrace more aggressive fiscal and credit stimulus, then they will reaccelerate the country’s flagging demand, which should benefit Australian exporters. If the increase in spending occurs in commodity-intensive parts of China’s economy, like construction, then Australia can also benefit from a terms-of-trade impact if commodity prices rise. However, BCA’s Geopolitical Strategy and China Investment Strategy remain skeptical that China will launch a major economic stimulus package along the lines of what occurred in 2015-16. That surge not only boosted Chinese GDP and import demand but also triggered a boost to global industrial commodity prices that benefitted many commodity exporters, including Australia. In recent months, there has been a pickup in overall Chinese import growth, as well as some acceleration of higher frequency growth indicators like the Li Keqiang index (Chart 4). Australian exports to China have not picked up though, and Chinese iron ore imports are contracting. Part of that is due to the elevated levels of Chinese iron ore inventories. More likely, there is little demand for additional iron ore given China’s reform agenda and the struggles of its construction sector (which accounts for roughly 35% of Chinese steel demand). Chart 4China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? Our colleagues at BCA China Investment Strategy2 have noted that both weakening sales and tighter funding sources for real estate developers point to declining growth in property starts and construction. This will be negative for construction-related commodity markets and construction-related machinery. This is coming at a time when the Chinese government is trying specifically to address over-indebted industries like construction. As for the U.S.-China trade truce, a permanent de-escalation of tensions – which has not yet occurred – could provide a boost to Australian export demand, as with other export-focused countries. But the negative impact of bilateral U.S.-China tariffs on the global economy is much smaller than that of China’s attempt to limit indebtedness. Moreover, a trade truce will remove China’s primary incentive to adopt more aggressive stimulus. Nevertheless, from the RBA’s perspective, any boost to China’s construction-related activity would have a big impact on Australia’s economy and would strengthen the case for a rate hike in 2019.  Core Inflation Australia’s headline CPI inflation has struggled to hit even the bottom end of the RBA’s 2-3% target band since 2015, reaching only 1.9% in Q3 of this year (Chart 5). The story is even worse for inflation excluding food and energy, with core CPI inflation now only at 1.2% after having drifted lower in two consecutive quarters. Both market-based and survey-based measures of inflation expectations are also hovering near 2%. Chart 5Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target When breaking down the CPI into tradeables (i.e. more globally-focused) and non-tradeables (i.e. more domestically-focused), the two types of inflation have not been accelerating at the same time since the 2009-11 period. Since then, faster tradeables inflation has occurred alongside slowing non-tradeables inflation, and vice versa.  While volatility on the tradeables side should be expected given the correlation to swings in commodity prices and the Australian dollar, the weakness in non-tradeables is more directly related to the spare capacity in the domestic economy. Therefore, if wage growth continues to pick up as the labor market tightens, then non-tradeables inflation should follow suit and boost Australian CPI inflation back towards the RBA target range. The implication for the RBA is that a move in core CPI inflation back towards 2.5% (the midpoint of the RBA band), occurring after an acceleration in wage growth as described above, would give the central bank confidence that a higher Cash Rate is required. Bottom Line: The RBA has kept interest rates on hold for over two years, but may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band. A more aggressive fiscal and monetary stimulus package in China, while not our base case, would also embolden the RBA to tighten monetary policy. Risks From Australian Banks? Throughout 2018, the Australian financial industry has had to endure the slings and arrows of a government inquiry into its questionable business practices and misconduct. Revelations of bribery, fraud, the charging of fees for no service and from the accounts of deceased people, as well as board-level deception of regulators, have roiled Australia's financial sector since the explosive inquiry began in February. The final report of the Australian Financial Services Royal Commission will be published in February, but the impact is already being felt throughout the industry. Bank CEOs have been publically shamed, while other senior financial sector executives have been forced from their jobs. The chairman of National Australia Bank stated before the inquiry that customers’ trust in lenders had been “pretty well eroded to zero”, and that it could take as long as a decade to successfully overhaul the culture within the banks. The biggest impacts from the Commission will come through hits to banks’ earnings and funding costs, as well as the potential impact on lending standards for new loans. Australian banks will be less profitable because of fines, customer refunds, setting aside provisions for potential misconduct penalties and the government wanting increased competition. If banks also choose to be more conservative with the marking of loans, then higher loan-loss provisions could be an additional drag on bank earnings. Already, Australian bank stocks have severely underperformed the overall domestic market, and there has been some slowing of domestic credit growth (Chart 6). There are also signs of bank funding stresses from contracting bank deposit growth (second panel) and wider offshore funding costs like relatively elevated LIBOR-OIS spreads (bottom panel). Considering how heavily Australian banks rely on offshore funding, any squeeze in those markets could severely influence the availability of credit within the Australian economy. Chart 6Australian Banks Under Some Stress... Australian Banks Under Some Stress... Australian Banks Under Some Stress... Looking ahead, if banks do tighten up their lending standards in response to the criticism and findings of the Commission, that will be from a starting point of very accommodative levels. In other words, getting a loan will likely still be “easy”, rather than “incredibly easy”. The reason is that Australian bank balance sheets remain in excellent condition. Credit crunches begin when banks are undercapitalized and are forced to retrench new loan activity as losses on existing loans pile up. That is not the case in Australia, where the major banks have Tier 1 capital ratios in the 10-12% range and non-performing loans are a tiny share of total lending. In our view, a true credit crunch would likely only occur after the Australian housing bubble bursts and the economy enters a severe downturn. That outcome would most likely be triggered by monetary policy tightening via multiple RBA rate hikes. Importantly, some of the steam has already been taken out of Australian house prices thanks to changes in regulations on new lending (Chart 7), potentially reducing some of the immediate risks to growth from a sharp plunge in home values.  Chart 7...But No Credit Crunch Expected ...But No Credit Crunch Expected ...But No Credit Crunch Expected Bottom Line: In 2019, the Australian government and its key financial regulators will have to work together to enforce responsible lending without triggering a catastrophic property market unwind. RBA policymakers are less likely to hike rates given their desire to maintain financial stability in the aftermath of the Commission – or at least until the inflation story forces their hand, as outlined in this report. The Federal Election: Polling Slightly Favors Labor Scandals in the financial sector are of utmost importance to the other major factor that could make 2019 a year of significant change in Australia: the federal election that looms most likely in the spring. Parliament is balanced on a knife’s edge, with the Australian Liberal Party’s loss of former Prime Minister Malcolm Turnbull’s parliamentary seat in a Sydney by-election on October 20. The ruling Liberal-National Coalition no longer has a majority and must rely on independent MPs to survive any no-confidence vote. This precarious situation suggests that the election could come even sooner than May and that the slightest twist in the campaign could deliver at least a small majority to either of the top two parties. Indeed, at this early stage, a high-conviction view on the election outcome is not warranted. After all, the 2016 election was decided in the Coalition’s favor only after a shift in opinion in the final month! Chart 8Labor Party Narrowly Leads All-Party Opinion Polls A Year Of Change In Australia? A Year Of Change In Australia? Nevertheless, with all due caveats, our baseline case is for a Labor majority in 2019, however slim it may be.3 Labor is slightly ahead of the Coalition in the primary opinion polling, which includes all parties (Chart 8). In two-party preference polling, Labor has gradually widened its general lead since the July 2016 election and now holds a 10% advantage in the federal polls – albeit only a 6% lead when a moving average is taken (Chart 9). Labor is also winning or tied in every major state. Chart 9Labor Has Large Lead In Two-Party Preference Polls A Year Of Change In Australia? A Year Of Change In Australia? The dramatic shift in polling since August is significant because that is when the knives came out and the Coalition ousted Turnbull in favor of the current Prime Minister Scott Morrison. The purpose of this move was to give the party a facelift ahead of the election. It is true that public opinion views Morrison as the preferred prime minister to Labor’s Bill Shorten. Shorten has a negative net approval rating and has never been viewed as an inspiring politician, while Morrison is just barely net positive. This perception works against Labor’s lead in the party polling – which is very competitive anyway – and suggests the election will be close. Critically, the Liberal-National Coalition’s polling as a whole has not benefited from the change in leadership. And in fact the data does not support the two major Australian parties’ abiding belief that a leadership coup will boost their popularity: Australia has seen four of these coups since 2010, two from Labor and two from the Coalition, and the party in question lost an average of 8% of the popular vote and 14 seats in parliament in the succeeding election (Table 1). Table 1Intra-Party Coups Don’t Win Votes A Year Of Change In Australia? A Year Of Change In Australia? Turnbull’s ouster also calls attention to another detrimental factor for the Coalition: the challenge on the right flank from minor and anti-establishment parties. Pauline Hanson’s One Nation has a relatively low support rate both historically and in today’s race, currently at 8%, but anti-establishment feeling may have forced the Coalition into an error. Judging by the party’s weak polling since August, the negative response to Turnbull’s ouster has been more detrimental than the nomination of Morrison, an immigration hardliner and social conservative, has been beneficial. Meanwhile, Labor’s momentum has been corroborated by a string of surprise victories in by-elections and a sweeping win in the Victoria state elections on November 24. In the latter case, the party not only defended its hold on government, as one might expect in this progressive state, but exceeded expectations to win 56 seats out of 88 in the lower House, while the Coalition lost nearly half of its seats, falling from 37 to 21. Still, Labor’s lead is by no means decisive. In the average of the various primary polls its edge over the Coalition is within the margin of error. Moreover, the Coalition holds more “safe” (uncompetitive) seats than Labor.4 The bottom line is that a small swing in either party’s favor can produce a thin majority. The Coalition’s best case is the economy. But as concerns about unemployment and job creation recede, voters will make other demands. The top issues in recent polling are the cost of living, health care, housing affordability, and wages. Some polls also emphasize social mobility and climate change and renewable energy. Will Shorten’s Labor Party be able to capture the median voter? It is highly significant that the party has taken a rightward turn on immigration and taxes even as it holds out a more left-wing agenda on health, education, regulation, and social benefits. Immigration has played a major role in Australian politics and Labor is currently positioned near the political center – in other words, if Morrison hardens his line to guard against populists, he risks over-hardening and moving away from the median voter (Chart 10). Shorten has proposed a large bipartisan task force to determine the proper limits to immigration and how to deal with congestion and infrastructure pressures. Shorten’s platform also calls attention to abuse of temporary visas by foreign workers. Chart 10Labor Is Not Too Soft On Immigration A Year Of Change In Australia? A Year Of Change In Australia? On taxes, Shorten has attempted to separate small and big companies, again in a bid for the political center. When Prime Minister Morrison sought to establish his anti-tax credentials (Chart 11), Shorten met him halfway and proposed relief for middle class families and small and medium-sized enterprises. Yet he doubled down on higher taxes for multinational corporations and high-income earners. Chart 11Liberal-National Coalition Cutting Corporate Tax Rates A Year Of Change In Australia? A Year Of Change In Australia? Critically, the latter redistributive stances are more in line with the median voter than the Liberal Party’s more conservative, supply-side, tax cut agenda. All of Australia’s parties, including the increasingly popular “minority parties,” have a more favorable attitude toward redistribution than the Coalition, which is the outlier (Chart 12). Indeed, the National Party is closer in line with the others than the Liberals, highlighting the divisions within the Coalition that have been jeopardizing votes. As for tax cuts on middle income earners and small businesses, Labor’s acceptance of them speaks to voter concerns about living costs, jobs, and wages. Chart 12The Coalition Is Out Of Synch On Taxes A Year Of Change In Australia? A Year Of Change In Australia? Labor is also closer to the median voter on the aforementioned financial sector scandals. The Coalition stands to suffer because it has developed a reputation for being too cozy with the banks (Chart 13). This is one of the biggest perceived differences between the two major parties – in addition to the negative perception of intra-Coalition betrayal – and it is possibly one of the most salient issues in the election. This presents a serious danger for the Coalition. Chart 13Banks: The Coalition’s Ball And Chain A Year Of Change In Australia? A Year Of Change In Australia? What would a Labor government bring? The market will be jittery about Shorten’s attempts to increase tax revenue, which threatens a non-negligible tightening of fiscal policy. Shorten wants to raise taxes on high income earners; remove or lower deductions and discounts (such as on capital gains); crack down on tax evasion; and tighten control over a range of tax practices specific to Australia (limiting “negative gearing” and cutting cash refunds for “franking credits”). He is also taking a tough position on banks and the energy sector. At the same time, it is clear from Labor’s proposals in 2016 (Chart 14) that there will be a hefty amount of new spending coming down the pike if a Labor government is formed – primarily on education, health, infrastructure and job training. The tax cuts that Shorten does support will go to those with a higher propensity to consume, as well as to SMEs that are responsible for job creation. Chart 14Labor’s Spending Plans Unlikely To Change Much A Year Of Change In Australia? A Year Of Change In Australia? Ultimately, Australia’s recent history, taken in consideration with the global business cycle, does not suggest that the Labor Party is all that much more fiscally profligate than the Coalition – but the current budget balance does suggest that there is substantial room to increase deficits, which is convenient for a government that is predisposed to give voters more services (Chart 15). Hence fiscal easing is the path of least resistance - one that could make the RBA even more comfortable in raising interest rates if the conditions laid out earlier in this report come to pass. Chart 15Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Bottom Line: The Australian Labor Party is slightly favored to win the next Australian election. This is a low-conviction call given the tight competition in public opinion polling and other mixed indicators. Broadly speaking, Labor’s shift to the political center on immigration and some tax issues makes the party more electable relative to the Coalition; meanwhile its promise of more government services fits with voter demands. We do not accept the narrative that Shorten’s Labor Party will engage in substantial fiscal tightening. The path of least resistance is for tax cuts as well as revenue collection, and for greater government spending. On the other hand, if the Coalition capitalizes on the incumbent advantage and stays in power, larger tax cuts will be in store. Hence we expect Australia to see marginally larger-than-expected budget deficits and fiscal thrust as the one reliable takeaway of next year’s election. Fixed Income Investment Implications We continue to recommend an overweight stance on Australian government bonds in currency-hedged global bond portfolios. While we have laid out the conditions that would make us change that view in this report, it is still too soon to position for such a move. Our RBA Monitor, which measures the cyclical pressures on the central bank to change monetary policy settings, is modestly below the zero line (Chart 16). This indicates a need for easier policy, although the indicator is starting to rise driven by the inflation components in the Monitor (bottom panel). In terms of market pricing, there are only 15bps of rate hikes over the next year discounted in the Australian Overnight Index Swap (OIS) curve, so markets are exposed to any shift to a more hawkish bias by the RBA as 2019 progresses. Chart 16Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Looking purely at Australian government bond yields, the forward curves are priced for very little change in yields over the next year (Chart 17). This suggests that outright duration trades in Australia look uninteresting from a carry perspective of betting against the forwards. We continue to prefer Australian bonds on a relative basis to global developed market peers until there is more decisive evidence pointing to convergence of Australian growth and inflation to the other major economies (bottom panel). Chart 17Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Over the past year, Global Fixed Income Strategy has recommended tactical trades in Australian money market futures to fade the pricing of RBA hikes that we did not expect to materialize. Specifically, we entered a long position in December 2018 Australian 90-Day Bank Bill futures on October 17, 2017, then switched to a long October 2019 90-Day Bank Bill futures position on May 29, 2017. The latter contract is now trading at implied interest rate levels just above the RBA’s 1.5% Cash Rate (Chart 18), suggesting that there is no more value in this trade.  Chart 18Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade We therefore take a profit of 21bps on the Bank Bill futures trade, while awaiting evidence from the “RBA Hike Checklist” introduced in this report before considering trades that will benefit from a more hawkish central bank.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1      Technically the House of Representatives election could occur as late as November 2, while the half Senate election is due May 18, but the norm is to hold the election simultaneously. The 2016 election was a “double dissolution” involving the election of the entire Senate and House of Representatives.  2      Please see BCA China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018, available at cis.bcareserach.com. 3      We would slightly favor Labor leading a slim majority in the Senate as well as in the House. In the Senate, the half of the seats that are up for grabs are evenly split and the polling at this early stage favors Labor over the Coalition. The poor performance of the Greens, in recent polling and in the Victoria state election, suggests a positive development for Labor on the margin, whereas One Nation, whose polls are improving, poses a threat to the Coalition. 4      Labor is fighting for 15 “marginal” (hotly contested) seats and 28 “fairly safe” seats, while the Coalition is only fighting for 12 marginal seats and 14 fairly safe seats.  

Highlights Chart 1Looking For Peak Credit Spreads Looking For Peak Credit Spreads Looking For Peak Credit Spreads   The sell-off in spread product continued through November, driven by that toxic combination of weakening global growth and tightening Fed policy. With spreads now looking more attractive, we have begun to search for catalysts that could throw the current sell-off into reverse. Chart 1 shows two catalysts that called the peak in credit spreads in early 2016: A move higher in the CRB Raw Industrials index – a sign of improving global demand – and a shift down in our 12-month Fed Funds Discounter – a sign of easier Fed policy. The recovery in the CRB index is so far only tentative, and despite Chairman Powell’s dovish tone last week, the Fed will need to see more credit market pain before hitting pause on the rate hike cycle. As such, we anticipate further spread widening during the next few months. On a cyclical (6-12 month) horizon, we continue to recommend a neutral allocation to spread product versus Treasuries and, given that the market is only priced for 44 bps of rate hikes during the next 12 months, a below-benchmark portfolio duration stance. Feature Investment Grade: Neutral Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 120 basis points in November, dragging year-to-date excess returns down to -216 bps. The index option-adjusted spread widened 19 bps on the month and currently sits at 137 bps. Corporate bonds are no longer expensive. The 12-month breakeven spread for Baa-rated debt is almost back to its average historical level (Chart 2). However, as was noted in last week’s report and on the first page of this report, the combination of weakening global growth and Fed tightening makes further widening likely in the near term.1 Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview A period of outperformance will follow the current bout of spread widening once global growth re-accelerates and/or the Fed adopts a more dovish policy stance. Therefore, on a cyclical (6-12 month) horizon we maintain a neutral allocation to corporate bonds. Pre-tax corporate profits grew 22% (annualized) in Q3 and a stunning 16% during the past year, well above the rate of corporate debt accumulation (bottom panel). But going forward, the stronger dollar and accelerating wages will cause profit growth to slow in the first half of 2019, triggering a renewed increase in gross leverage (panel 4). With that in mind, we continue to recommend that investors maintain an up-in-quality bias within a neutral allocation to corporate bonds. We prefer to pick-up extra spread by favoring the long-end of the credit curve.2 High-Yield: Neutral High-Yield underperformed the duration-equivalent Treasury index by 155 basis points in November, dragging year-to-date excess returns down to +4 bps. The average index option-adjusted spread widened 47 bps on the month, and currently sits at 418 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 308 bps, nicely above its long-run average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast during the next 12 months, high-yield bonds will return 308 bps in excess of duration-matched Treasuries, assuming no change in spreads. Factoring-in enough spread compression to bring the default-adjusted spread back to its historical average leads to an expected excess return of 534 bps. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview For a different perspective on valuation, we can also calculate the default rate necessary for the High-Yield index to deliver 12-month excess returns in line with the historical average. As of today, this spread-implied default rate is 3.20%, well above the 2.26% default rate anticipated by Moody’s (panel 4). While the elevated spread-implied default rate is certainly a sign of improved value, our sense is that the actual default rate will end up closer to the spread-implied level than to the level expected by Moody’s. Job cut announcements – an excellent indicator of corporate defaults – have put in a clear bottom (bottom panel) and the third quarter Senior Loan Officer Survey showed a decline in C&I loan demand, often a precursor of tighter lending standards.3  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* More Pain Required More Pain Required   Table 3BCorporate Sector Risk Vs. Reward* More Pain Required More Pain Required MBS: Neutral Mortgage-Backed Securities performed in line with the duration-equivalent Treasury index in November, keeping year-to-date excess returns steady at -43 bps. The conventional 30-year zero-volatility spread was flat on the month. A basis point widening in the option-adjusted spread (OAS) was offset by a basis point drop in the compensation for prepayment risk (option cost). Although very low mortgage refinancings have kept overall MBS spreads tight, the option-adjusted spread has widened in recent months, bringing some value back to the sector (Chart 4). Chart 4MBS Market Overview MBS Market Overview MBS Market Overview In last week’s report we ran a performance attribution on excess MBS returns for 2018.4 We found that interest rate volatility had been a drag on MBS returns early in the year, but the sector’s most recent underperformance was almost entirely due to OAS widening. Mortgage refinancing risk, typically the most important risk factor, contributed positively to excess returns throughout most of the year. With Fed rate hikes likely to keep refinancings low, and with mortgage lending standards still easing from restrictive levels (bottom panel), the macro back-drop remains very supportive for MBS spreads. We maintain a neutral allocation to the sector for now, but will likely upgrade when it comes time to further pare our allocation to corporate credit. Government-Related: Underweight The Government-Related index underperformed the duration-equivalent Treasury index by 33 basis points in November, dragging year-to-date excess returns down to -50 bps. Sovereign debt underperformed the Treasury benchmark by 70 bps, dragging year-to-date excess returns down to -188 bps. Foreign Agencies underperformed by 68 bps, dragging year-to-date excess returns down to -128 bps. Local Authorities underperformed by 51 bps, dragging year-to-date excess returns down to +11 bps. Supranationals outperformed Treasuries by 5 bps, bringing year-to-date excess returns up to +19 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to +1 bp. Sovereign debt has underperformed this year, but spreads remain expensive compared to U.S. corporate credit and the dollar’s recent strength suggests that the sector will continue to struggle (Chart 5). Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview In a recent report we looked at USD-denominated Emerging Market Sovereign debt by country and found that only a few nations offer excess spread compared to equivalently-rated U.S. corporates.5 Those countries are Argentina, Turkey, Lebanon and Ukraine at the low-end of the credit spectrum and Saudi Arabia, Qatar and UAE at the upper-end. We continue to view the Local Authority sector as very attractive. The sector offers similar value to Aa/A-rated corporate debt on a breakeven spread basis (bottom panel), and it is also dominated by taxable municipal securities that are insulated from weak foreign economic growth. Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 6 basis points in November, dragging year-to-date excess returns down to +99 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 2% in November, and currently sits at 86% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1975, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and +50 bps (where it stands today) investment grade corporate bonds have delivered annualized excess returns of -11 bps. In contrast, municipal bonds have delivered annualized excess returns of +156 bps before adjusting for the tax advantage. We attribute this mid-cycle outperformance to the fact that state & local government balance sheet health tends to lag the health of the corporate sector. At present, our Municipal Health Monitor remains in “improving health” territory, consistent with an environment where ratings upgrades will outpace downgrades (bottom panel). Meanwhile, corporations are already deep into the releveraging process. Treasury Curve: Favor The 2-Year Bullet Over The 1/5 Barbell Treasury yields fell in November, led by the 5-10 year maturities. The 2/10 slope flattened 7 bps to end the month at 21 bps. The 5/30 slope steepened 5 bps to end the month at 46 bps. In a recent report we demonstrated that the best place to position on the Treasury curve has shifted from the 5-7 year maturity point to the 2-year maturity point.6 Our sense is that the 2-year note offers the best combination of risk and reward of any point on the Treasury curve, both in absolute and duration-neutral terms. The 2/5 Treasury slope was 31 bps at the beginning of 2018, but has flattened all the way down to 4 bps over the course of this year. Factoring in the greater roll-down at the short-end of the curve, we find that the 2-year note would actually outperform the 5-year note in an unchanged yield curve scenario. This sort of carry advantage in the 2-year note is relatively rare, and tends to occur only when the yield curve is inverted. Attractive compensation at the front-end of the curve provides an opportunity for investors to buy the 2-year note and short a duration-matched 1/5 barbell. Our model shows that the 2 over 1/5 butterfly spread is priced for 18 bps of 1/5 flattening during the next six months (Chart 7). In other words, if the 1/5 slope steepens or flattens by less than 18 bps, our position long the 2-year and short the 1/5 will outperform.   Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in November, dragging year-to-date excess returns down to +21 bps. The 10-year TIPS breakeven inflation rate fell 8 bps on the month and currently sits at 1.97%. The 5-year/5-year forward TIPS breakeven inflation rate fell 3 bps on the month and currently sits at 2.17%. Long-maturity TIPS breakeven inflation rates finally capitulated and have fallen sharply alongside the prices of oil and other commodities during the past two months. Breakevens continue to grapple with the competing forces of falling commodity prices on the one hand, and relatively strong U.S. inflation on the other. Eventually, the decisive factor in the TIPS market will be core U.S. inflation continuing to print close to the Fed’s 2% target. This will drive both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates back into a range between 2.3% and 2.5%, although the headwind from weak commodity prices could persist for a while longer. In a recent report we showed that the 10-year TIPS breakeven rate is very close to the fair value reading from our Adaptive Expectations Model (Chart 8).7 This model is based on a combination of long-run and short-run inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. In other words, the market will need to see core inflation print close to the Fed’s target for some time before deciding that it will remain there on a sustained basis.    Chart 8Inflation Compensation Inflation Compensation Inflation Compensation ABS: Neutral Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in November, dragging year-to-date excess returns down to +21 bps. The index option-adjusted spread for Aaa-rated ABS widened 4 bps on the month and now stands at 42 bps, 8 bps above its pre-crisis low. The Fed’s Senior Loan Officer Survey for Q3 showed that average consumer credit lending standards eased for the first time since early 2016 (Chart 9). Consistent with a somewhat more supportive lending environment, the consumer credit delinquency rate has been roughly flat on a year-over-year basis. However, given the continued uptrend in household interest coverage, consumer credit delinquencies are biased higher (panel 4). Chart 9ABS Market Overview ABS Market Overview ABS Market Overview The excess return Bond Map on page 15 shows that consumer ABS offer greater expected returns than Domestic Agencies and Supranationals, though with a commensurate increase in risk. The Map also shows that Agency CMBS offer very similar return potential with much less risk. We maintain a neutral allocation to consumer ABS for now. As consumer credit delinquencies continue to rise, our next move will likely be a reduction to underweight. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 37 basis points in November, dragging year-to-date excess returns down to +82 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps on the month and currently sits at 80 bps (Chart 10). Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview A typical negative environment for CMBS is characterized by tightening bank lending standards on commercial real estate loans as well as falling demand. The Fed’s Q3 Senior Loan Officer Survey showed that lending standards are close to unchanged and that demand deteriorated. All in all, a slightly negative macro picture for CMBS that will bear close monitoring in the coming quarters. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in November, dragging year-to-date excess returns down to +14 bps. The index option-adjusted spread widened 5 bps on the month and currently sits at 56 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of November 30, 2018) More Pain Required More Pain Required   Chart 12Total Return Bond Map (As Of November 30, 2018) More Pain Required More Pain Required   Table 4Butterfly Strategy Valuation (As Of November 30, 2018) More Pain Required More Pain Required   Table 5Discounted Slope Change During Next 6 Months (BPs) More Pain Required More Pain Required ​​​​​​​   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com​​​​​​​ Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What Kind Of Correction Is This?”, dated October 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Oil Supply Shock Is A Risk For Junk”, dated October 9, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “The Sweet Spot On The Yield Curve”, dated November 13, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights On a 6-month horizon, go long a combination of banks and high quality 10-year bonds. The recommended combination is 25 cents in the banks and 75 cents in the bonds. The preferred banks are European or euro area and the preferred bonds are U.S. T-bonds. Stay short oil and gas versus financials. During December, use any sharp sell-offs in sterling to buy the pound… …and to downgrade the FTSE100 to underweight. Feature Chart of the WeekBanks And Bond Yields Were Connected At The Hip... Until This Year Banks And Bond Yields Were Connected At The Hip... Until This Year Banks And Bond Yields Were Connected At The Hip... Until This Year Back in June, in Oddities In The 1st Half, Opportunities In The 2nd Half we pointed out two striking oddities in financial market behaviour. One oddity was the sharp decoupling of crude oil from industrial commodity prices (Chart I-2). It is highly unusual for crude oil to outperform copper by 50 percent in the space of just six months. We argued that such an extreme deviation would have to correct one way or another. Which of course it did… Chart I-2Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled The other oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-3 and Chart of the Week). Bank equity prices and bond yields are usually connected at the hip. The tight connection exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart I-3Banks Decoupled From Bond Yields... But Will Recouple Banks Decoupled From Bond Yields... But Will Recouple Banks Decoupled From Bond Yields... But Will Recouple On the back of these two striking oddities, we recommended a compelling trade: short oil and gas versus financials. This trade is now in profit and has further to run, but today we want to introduce a new trade: go long a combination of banks and bonds. Explaining The Oddities Of 2018 The underperformance of banks from February through September was entirely consistent with similar underperformances in the other classically growth-sensitive sectors – industrials, and basic materials as well as the decline in industrial commodity prices (Chart I-4). Furthermore, these underperformances started well before any inkling of a trade war. This suggests that the cyclical sector underperformances were correctly reflecting a common or garden down-oscillation in global growth. Chart I-4Oil And Gas Was The Odd Man Out Oil And Gas Was The Odd Man Out Oil And Gas Was The Odd Man Out Oil was a striking oddity because its supply dynamics, rather than its demand dynamics, were dominating its price action, at one point lifting its year-on-year inflation rate to 70 percent for Brent and 80 percent for WTI. Part of this surge in year-on-year inflation was also to do with the ‘base effect’, the dip in the oil price to $45 in the summer of 2017. The base effect shouldn’t really bother markets. After all, most people do not consciously compare a price today with the price precisely a year ago. The problem is that central banks do compare a price today with the price precisely a year ago in their inflation targets. Clearly, when oil price inflation was running at 80 percent, it was underpinning headline CPI inflation, central bank reaction functions, and thereby bond yields. Hence, the two striking oddities – oil abruptly decoupling from industrial commodities (Chart I-5) and bond yields abruptly decoupling from banks – are two sides of the same coin. From February through September, bond yields were taking their cue, at least partly, from the rising price of oil, given its major impact on headline inflation and on central bank reaction functions. Whereas banks, industrials, and industrial commodity prices were taking their cue from fading global growth and industrial activity. Chart I-5It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months A Banks Plus Bonds Combination Could Be A Win-Win The oddities of 2018 are now correcting. With the oil price sharply lower, its year-on-year inflation rate has plunged to -10 percent (Chart I-6). Furthermore, as we have pointed out in recent reports, the sharp deceleration in global credit growth from February through September has clearly arrested and even reversed. The upshot is that banks and bond yields will recouple, one way or the other. Chart I-6Oil Inflation Down from 70% To -10% Oil Inflation Down from 70% To -10% Oil Inflation Down from 70% To -10% Most likely, global growth will rebound somewhat and the beaten-down bank equity prices have considerable scope for recovery (Chart I-7), while the restraint on headline CPI inflation will keep bond yields in check. Indeed, as President Trump recently tweeted: Chart I-7Global Growth Will Rebound, So Will Banks Global Growth Will Rebound, So Will Banks Global Growth Will Rebound, So Will Banks “Inflation down, are you listening Fed!” But if we are wrong and growth disappoints, bank equities are already beaten-down while a further downdraft in inflation will pull down bond yields. Either way, on a six month horizon a combination of banks and high quality 10-year bonds should be a win-win strategy. Given the different betas of the two investments, the recommended combination is 25 cents in the banks and 75 cents in the bonds. The preferred banks are European or euro area and the preferred bonds are U.S. T-bonds. Focus On Sectors And Currencies The remainder of this report is a reminder that successful macro investing requires the application of the Pareto Principle, also known as 80:20 rule. In macro investing, the vast majority of performance outcomes, ‘the 80’, are explained by a very small number of drivers, ‘the 20’. We find that the vast majority of a region’s or a country’s stock market relative performance is explained just by its distinguishing sector fingerprint combined with its currency (Chart I-8 - Chart I-12). Chart I-8Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-10FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars Chart I-11FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen Chart I-12FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros Major stock markets comprise of multinational companies whose sales and profits are internationally diversified. But each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint (Table I-1): FTSE100 = long energy, short technology. Eurostoxx50 = long banks, short technology. Nikkei225 = long industrials, short banks and energy. S&P500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Table I-1Each Major Stock Market Has A Distinguishing Fingerprint Oil, Banks, And Bonds: The Oddities Of 2018 Oil, Banks, And Bonds: The Oddities Of 2018 The other important factor is the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In other words, BP’s global business is currency neutral. But BP’s stock price is quoted in London in pounds. Hence, if the pound strengthens, the company’s multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. This means that the domestic economy can impact its stock market through the currency channel. Albeit it is a counterintuitive relationship: a strong economy via a strong currency hinders the stock market; a weak economy via a weak currency helps the stock market. What does all of this mean for our European country allocation right now? From a sector perspective, a stance that is short oil and gas versus financials penalises the FTSE100 versus the Eurostoxx50, given the FTSE100’s oil and gas fingerprint and the Eurostoxx50’s banks fingerprint. Against this, a weakening pound would support the FTSE100. Given that Theresa May’s Brexit agreement will meet stiff resistance when it comes to Parliament in the second week of December, the point of maximum risk for the pound is still ahead of us. But as we argued last week, we ultimately expect relief for the pound as: either the Article 50 process is extended, or the U.K. moves into a transition period within a negotiated Brexit.1 Hence, during December, use any sharp sell-offs in sterling to buy the pound, and to downgrade the FTSE100 to underweight.   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week we note that this year’s sell-off in Italian equities is technically very stretched. Therefore, in a continued de-escalation of the budget spat between Italy and the EU, Italian equities would be ripe for a strong countertrend burst of outperformance. On this basis, our recommended trade is long MIB versus the Eurostoxx with a profit target of 5% and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Long MIB Vs. Euro Stoxx Long MIB Vs. Euro Stoxx The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnote 1 Please see the European Investment Strategy Weekly Report “DM Versus EM, And Two European Psychodramas”, November 22, 2018 available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given the recent turbulence in financial markets. Our investments have done poorly in the past year and, with hindsight, I wish I had followed my instincts to significantly cut our equity exposure at the end of 2017, although we did follow your advice to move to a neutral stance in mid-2018. I remain greatly troubled by economic and political developments in many countries. I have long believed in open and free markets and healthy political discourse, and this all seems under challenge. As always, there is much to talk about. Ms. X: Let me add that I also am pleased to have this opportunity to talk through the key issues that will influence our investment strategy over the coming year. As I am sure you remember, I was more optimistic than my father about the outlook when we met a year ago but things have not worked out as well as I had hoped. In retrospect, I should have paid more attention to your view that markets and policy were on a collision course as that turned out to be a very accurate prediction. When I joined the family firm in early 2017, I persuaded my father that we should have a relatively high equity exposure and that was the correct stance. However, this success led us to maintain too much equity exposure in 2018, and my father has done well to resist the temptation to say “I told you so.” So, we are left with a debate similar to last year: Should we move now to an underweight in risk assets or hold off on the hope that prices will reach new highs in the coming year? I am still not convinced that we have seen the peak in risk asset prices as there is no recession on the horizon and equity valuations are much improved, following recent price declines. I will be very interested to hear your views. BCA: Our central theme for 2018 that markets and policy would collide did turn out to be appropriate and, importantly, the story has yet to fully play out. The monetary policy tightening cycle is still at a relatively early stage in the U.S. and has not even begun in many other regions. Yet, although it was a tough year for most equity markets, the conditions for a major bear market are not yet in place. One important change to our view, compared to a year ago, is that we have pushed back the timing of the next U.S. recession. This leaves a window for risk assets to show renewed strength. It remains to be seen whether prices will reach new peaks, but we believe it would be premature to shift to an underweight stance on equities. For the moment, we are sticking with our neutral weighting for risk assets, but may well recommend boosting exposure if prices suffer further near-term weakness. We will need more clarity about the timing of a recession before we consider aggressively cutting exposure. Mr. X: I can see we will have a lively discussion because I do not share your optimism. My list of concerns is long and I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: That is always interesting to do, although sometimes rather humbling. A year ago, our key conclusions were that: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflationary pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets.  The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the probability of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the Euro Area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China’s economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their “dots” projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal have real 10-year government bond yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The Euro Area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. As already noted, the broad theme that policy tightening – especially in the U.S. – would become a problem for asset markets during the year was supported by events. However, the exact timing was hard to predict. The indexes for non-U.S. developed equity markets and emerging markets peaked in late-January 2018, and have since dropped by around 18% and 24%, respectively (Chart 1). On the other hand, the U.S. market, after an early 2018 sell-off, hit a new peak in September, before falling anew in the past couple of months. The MSCI All-Country World index currently is about 6% below end-2017 levels in local-currency terms. Chart 1Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out We started the year recommending an overweight in developed equity markets but, as you noted, shifted that to a neutral position mid-year. A year ago, we thought we might move to an underweight stance in the second half of 2018 but decided against this because U.S. fiscal stimulus boosted corporate earnings and extended the economic cycle. Our call that emerging markets would underperform was on target. Although it was U.S. financial conditions that tightened the most, Wall Street was supported by the large cut in the corporate tax rate while the combination of higher bond yields and dollar strength was a major problem for many indebted emerging markets. Overall, it was not a good year for financial markets (Table 1). Table 1Market Performance OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence As far as the overall macro environment was concerned, we were correct in predicting that the IMF was too pessimistic on economic growth. A year ago, the IMF forecast that the advanced economies would expand by 2% in 2018 and that has since been revised up to 2.4% (Table 2). This offset a slight downgrading to the performance of emerging economies. The U.S., Europe and Japan all grew faster than previously expected. Not surprisingly, inflation also was higher than forecast, although in the G7, it has remained close to the 2% level targeted by most central banks. Table 2IMF Economic Forecasts OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Despite widespread fears to the contrary, the data have supported our view that Chinese growth would hold above a 6% pace in 2018. Nevertheless, a slowdown currently is underway and downside risks remain very much in place in terms of excessive credit and trade pressures. Another difficult year lies ahead for the Chinese authorities and we will no doubt return to this topic later. As far as our other key forecasts are concerned, we were correct in our views that oil prices and the U.S. dollar would rise and that the market would be forced to revise up its predictions of Fed rate hikes. Of course, oil has recently given back its earlier gains, but we assume that is a temporary setback. On the sector front, our macro views led us to favor industrials, financials and energy, but that did not work out well as concerns about trade took a toll on cyclical sectors. Overall, there were no major macro surprises in 2018, and it seems clear that we have yet to resolve the key questions and issues that we discussed a year ago. At that time, we were concerned about the development of late-cycle pressures that ultimately would undermine asset prices. That story has yet to fully play out. It is hard to put precise timing on when the U.S. economy will peak and, thus, when asset prices will be at maximum risk. Nevertheless, our base case is that there likely will be a renewed and probably final run-up in asset prices before the next recession. Late-Cycle Challenges Mr. X: This seems like déjà-vu all over again. Since we last met, the cycle is one year older and, as you just said, the underlying challenges facing economies and markets have not really changed. If anything, things are even worse: Global debt levels are higher, inflation pressures more evident, Fed policy is moving closer to restrictive territory and protectionist policies have ratcheted up. If it was right to be cautious six months ago, then surely we should be even more cautious now. Ms. X: Oh dear, it does seem like a repeat of last year’s discussion because, once again, I am more optimistic than my father. Obviously, there are structural problems in a number of countries and, at some point, the global economy will suffer another recession. But timing is everything, and I attach very low odds to a downturn in the coming year. Meanwhile, I see many pockets of value in the equity market. Rather than cut equity positions, I am inclined to look for buying opportunities. BCA: We sympathize with your different perspectives because the outlook is complex and we also have lively debates about the view. The global equity index currently is a little below where it was when we met last year, but there has been tremendous intra-period volatility. That pattern seems likely to be repeated in 2019. In other words, it will be important to be flexible about your investment strategy. You both make good points. It is true that there are several worrying problems regarding the economic outlook, including excessive debt, protectionism and building inflation risks. At the same time, the classic conditions for an equity bear market are not yet in place, and may not be for some time. This leaves us in the rather uncomfortable position of sitting on the fence with regard to risk asset exposure. We are very open to raising exposure should markets weaken further in the months ahead, but also are keeping careful watch for signs that the economic cycle is close to peaking. In other words, it would be a mistake to lock in a 12-month strategy right now. Mr. X: I would like to challenge the consensus view, shared by my daughter, that the next recession will not occur before 2020, and might even be much later. The main rationale seems to be that the policy environment remains accommodative and there are none of the usual imbalances that occur ahead of recessions. Of course, U.S. fiscal policy has given a big boost to growth in the past year, but I assume the effects will wear off sharply in 2019. More importantly, there is huge uncertainty about the level of interest rates that will trigger economic problems. It certainly has not taken much in the way of Fed rate hikes to rattle financial markets. Thus, monetary policy may become restrictive much sooner than generally believed. I also strongly dispute the idea that there are no major financial imbalances. If running U.S. federal deficits of $1 trillion in the midst of an economic boom is not an imbalance, then I don’t know what is! At the same time, the U.S. corporate sector has issued large amounts of low-quality debt, and high-risk products such as junk-bond collateralized debt obligations have made an unwelcome reappearance. It seems that the memories of 2007-09 have faded. It is totally normal for long periods of extremely easy money to be accompanied by growing leverage and increasingly speculative financial activities, and I don’t see why this period should be any different. And often, the objects of speculation are not discovered until financial conditions become restrictive. Finally, there are huge risks associated with rising protectionism, the Chinese economy appears to be struggling, Italy’s banks are a mess, and the Brexit fiasco poses a threat to the U.K. economy. Starting with the U.S., please go ahead and convince me why a recession is more than a year away. BCA: It is natural for you to worry that a recession is right around the corner. The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle. The Great Recession was one of the deepest downturns on record and the recovery has been fairly sluggish by historic standards. Thus, it has taken much longer than usual for the U.S. economy to return to full employment. Looking out, there are many possible risks that could trip up the U.S. economy but, for the moment, we see no signs of recession on the horizon (Chart 2). For example, the leading economic indicator is still in an uptrend, the yield curve has not inverted and our monetary indicators are not contracting. Our proprietary recession indicator also suggests that the risk is currently low, although recent stock market weakness implies some deterioration. Chart 2Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' The buildup in corporate debt is a cause for concern and we are not buyers of corporate bonds at current yields. However, the impact of rising yields on the economy is likely to be manageable. The interest coverage ratio for the economy as a whole – defined as the profits corporations generate for every dollar of interest paid – is still above its historic average (Chart 3). Corporate bonds are also generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. The impact of defaults on the economy tends to be more severe when leveraged institutions are the ones that suffer the greatest losses. Chart 3Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind We share your worries about the long-term fiscal outlook. However, large budget deficits do not currently imperil the economy. The U.S. private sector is running a financial surplus, meaning that it earns more than it spends (Chart 4). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its budget deficit. If anything, the highly accommodative stance of fiscal policy has pushed up the neutral rate of interest, giving the Fed greater scope to raise rates before monetary policy enters restrictive territory. The impetus of fiscal policy on the economy will be smaller in 2019 than it was in 2018, but it will still be positive (Chart 5). Chart 4The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit Chart 5U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 The risks to growth are more daunting outside the U.S. As you point out, Italy is struggling to contain borrowing costs, a dark cloud hangs over the Brexit negotiations, and China and most other emerging markets have seen growth slow meaningfully. The U.S., however, is a relatively closed economy – it is not as dependent on trade as most other countries. Its financial system is reasonably resilient thanks to the capital its banks have raised over the past decade. In addition, Dodd-Frank and other legislation have made it more difficult for financial institutions to engage in reckless risk-taking. Mr. X: I would never take a benign view of the ability and willingness of financial institutions to engage in reckless behavior, but maybe I am too cynical. Even if you are right that debt does not pose an immediate threat to the market, surely it will become a huge problem in the next downturn. If the U.S. federal deficit is $1 trillion when the economy is strong, it is bound to reach unimaginable levels in a recession. And, to make matters worse, the Federal Reserve may not have much scope to lower interest rates if they peak at a historically low level in the next year or so. What options will policymakers have to respond to the next cyclical downturn? Is there a limit to how much quantitative easing central banks can do? BCA: The Fed is aware of the challenges it faces if the next recession begins when interest rates are still quite low. Raising rates rapidly in order to have more “ammunition” for counteracting the downturn would hardly be the best course of action as this would only bring forward the onset of the recession. A better strategy is to let the economy overheat a bit so that inflation rises. This would allow the Fed to push real rates further into negative territory if the recession turns out to be severe. There is no real limit on how much quantitative easing the Fed can undertake. The FOMC will undoubtedly turn to asset purchases and forward guidance again during the next economic downturn. Now that the Fed has crossed the Rubicon into unorthodox monetary policy without generating high inflation, policymakers are likely to try even more exotic policies, such as price-level targeting. The private sector tends to try to save more during recessions. Thus, even though the fiscal deficit would widen during the next downturn, there should be plenty of buyers for government debt. However, once the next recovery begins, the Fed may feel increasing political pressure to keep rates low in order to allow the government to maintain its desired level of spending and taxes. The Fed guards its independence fiercely, but in a world of increasingly political populism, that independence may begin to erode. This will not happen quickly, but to the extent that it does occur, higher inflation is likely to be the outcome. Ms. X: I would like to explore the U.S.-China dynamic a bit more because I see that as one of the main challenges to my more optimistic view. I worry that President Trump will continue to take a hard line on China trade because it plays well with his base and has broad support in Congress. And I equally worry that President Xi will not want to be seen giving in to U.S. bullying. How do you see this playing out? BCA: Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the forthcoming G20 leaders' summit in Buenos Aires are likely to be disappointed. President Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It also forces the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger U.S. trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a trade agreement with them. The new USMCA agreement is remarkably similar to NAFTA, with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China. This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit and China will fill that role. For his part, President Xi knows full well that he will still be China’s leader when Trump is long gone. Giving in to Trump’s demands would hurt him politically. All this means that the trade war will persist. Mr. X: I see a trade war as a major threat to the economy, but it is not the only thing that could derail the economic expansion. Let’s explore that issue in more detail. The Economic Outlook Mr. X: You have shown in previous research that housing is often a very good leading indicator of the U.S. economy, largely because it is very sensitive to changes in the monetary environment. Are you not concerned about the marked deterioration in recent U.S. housing data? BCA: Recent trends in housing have indeed been disappointing, with residential investment acting as a drag on growth for three consecutive quarters. The weakness has been broad-based with sales, the rate of price appreciation of home prices, and builder confidence all declining (Chart 6). Even though the level of housing affordability is decent by historical standards, there has been a fall in the percentage of those who believe that it is a good time to buy a home. Chart 6Recent Softness In U.S. Housing Recent Softness In U.S. Housing Recent Softness In U.S. Housing There are a few possible explanations for the weakness. First, the 2007-09 housing implosion likely had a profound and lasting impact on the perceived attractiveness of home ownership. The homeownership rate for people under 45 has remained extremely low by historical standards. Secondly, increased oversight and tighter regulations have curbed mortgage supply. Finally, the interest rate sensitivity of the sector may have increased with the result that even modest increases in the mortgage rate have outsized effects. That, in turn, could be partly explained by recent tax changes that capped the deduction on state and local property taxes, while lowering the limit on the tax deductibility of mortgage interest. The trend in housing is definitely a concern, but the odds of a further major contraction seem low. Unlike in 2006, the home vacancy rate stands near record levels and the same is true for the inventory of homes. The pace of housebuilding is below the level implied by demographic trends and consumer fundamentals are reasonably healthy. The key to the U.S. economy lies with business investment and consumer spending and these areas are well supported for the moment. Consumers are benefiting from continued strong growth in employment and a long overdue pickup in wages. Meanwhile, the ratio of net worth-to-income has surpased the previous peak and the ratio of debt servicing-to-income is low (Chart 7). Last year, we expressed some concern that the depressed saving rate might dampen spending, but the rate has since been revised substantially higher. Based on its historical relationship with U.S. household net worth, there is room for the saving rate to fall, fueling more spending. Real consumer spending has grown by 3% over the past year and there is a good chance of maintaining that pace during most of 2019. Chart 7U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy Turning to capital spending, the cut in corporate taxes was obviously good for cash flow, and surveys show a high level of business confidence. Moreover, many years of business caution toward spending has pushed up the average age of the nonresidential capital stock to the highest level since 1963 (Chart 8). Higher wages should also incentivize firms to invest in more machinery. Absent some new shock to confidence, business investment should stay firm during the next year. Chart 8An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. As discussed earlier, that means capacity pressures will intensify, causing inflation to move higher. Ms. X: I share the view that the U.S. economy will continue to grow at a healthy pace, but I am less sure about the rest of the world. BCA: You are right to be concerned. We expected U.S. and global growth to diverge in 2018, but not by as much as occurred. Several factors have weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, higher oil prices, emerging market turbulence, the return of Italian debt woes, and a slowdown in the Chinese economy. The stress has shown up in the global manufacturing PMI, although the latter is still at a reasonably high level (Chart 9). Global export growth is moderating and the weakness appears to be concentrated in capex. Capital goods imports for the major economies, business investment, and the production of investment-related goods have all decelerated this year. Chart 9Global Manufacturing Slowdown Global Manufacturing Slowdown Global Manufacturing Slowdown Our favorite global leading indicators are also flashing yellow (Chart 10). BCA’s global leading economic indicator has broken below the boom/bust line and its diffusion index suggests further downside. The global ZEW composite and the BCA boom/bust indicator are both holding below zero. Chart 10Global Growth Leading Indicators Global Growth Leading Indicators Global Growth Leading Indicators Current trends in the leading indicators shown in Chart 11 imply that the growth divergence between the U.S. and the rest of the world will remain a key theme well into 2019. Among the advanced economies, Europe and Japan are quite vulnerable to the global soft patch in trade and capital spending. Chart 11Global Economic Divergence Will Continue Global Economic Divergence Will Continue Global Economic Divergence Will Continue The loss of momentum in the Euro Area economy, while expected, has been quite pronounced. Part of this is due to the dissipation of the 2016/17 economic boost related to improved health in parts of the European banking system that sparked a temporary surge in credit growth. The tightening in Italian financial conditions following the government’s budget standoff with the EU has weighed on overall Euro Area growth. Softer Chinese demand for European exports, uncertainties related to U.S. trade policy and the torturous Brexit negotiations, have not helped the situation. Real GDP growth decelerated to close to a trend pace by the third quarter of 2018. The manufacturing PMI has fallen from a peak of 60.6 in December 2017 to 51.5, mirroring a 1% decline in the OECD’s leading economic indicator for the region. Not all the economic news has been bleak. Both consumer and industrial confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with a resumption of above-trend growth. Even though exports have weakened substantially from the booming pace in 2017, the EC survey on firms’ export order books remains at robust levels (Chart 12). Importantly for the Euro Area, the bank credit impulse has moved higher.The German economy should also benefit from a rebound in vehicle production which plunged earlier this year following the introduction of new emission standards. Chart 12Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster We interpret the 2018 Euro Area slowdown as a reversion-to-the-mean rather than the start of an extended period of sub-trend growth. Real GDP growth should fluctuate slightly above trend pace through 2019. Given that the Euro Area’s output gap is almost closed, the ECB will not deviate from its plan to end its asset purchase program by year end. Gradual rate hikes should begin late in 2019, assuming that inflation is closer to target by then. In contrast, the Bank of Japan (BoJ) is unlikely to change policy anytime soon. The good news is that wages have finally begun to grow at about a 2% pace, although it required extreme labor shortages. Yet, core inflation is barely positive and long-term inflation expectations are a long way from the 2% target. The inflation situation will have to improve significantly before the BoJ can consider adjusting or removing the Yield Curve Control policy. This is especially the case since the economy has hit a bit of an air pocket and the government intends to raise the VAT in 2019. Japan’s industrial production has stalled and we expect the export picture to get worse before it gets better. We do not anticipate any significant economic slack to develop, but even a sustained growth slowdown could partially reverse the gains that have been made on the inflation front. Ms. X: We can’t talk about the global economy without discussing China. You have noted in the past how the authorities are walking a tightrope between trying to unwind the credit bubble and restructure the economy on the one hand, and prevent a destabilizing economic and financial crisis on the other. Thus far, they have not fallen off the tightrope, but there has been limited progress in resolving the country’s imbalances. And now the authorities appear to be stimulating growth again, risking an even bigger buildup of credit. Can it all hold together for another year? BCA: That’s a very good question. Thus far, there is not much evidence that stimulus efforts are working. Credit growth is still weak and leading economic indicators have not turned around (Chart 13). There is thus a case for more aggressive reflation, but the authorities also remain keen to wean the economy off its addiction to debt. Chart 13China: No Sign Of Reacceleration China: Credit Impulse Remains Weak China: Credit Impulse Remains Weak Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to about 260% of GDP at present (Chart 14). As is usually the case, rapid increases in leverage have been associated with a misallocation of capital. Since most of the new credit has been used to finance fixed-asset investment, the result has been overcapacity in a number of areas. For example, the fact that 15%-to-20% of apartments are sitting vacant is a reflection of overbuilding. Meanwhile, the rate of return on assets in the state-owned corporate sector has fallen below borrowing costs. Chart 14China: Debt Still Rising China: Debt Still Rising China: Debt Still Rising Chinese exports are holding up well so far, but this might only represent front-running ahead of the implementation of higher tariffs. Judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, exports are likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 15). Chart 15Chinese Exports About To Suffer Chinese Exports About To Suffer Chinese Exports About To Suffer The most likely outcome is that the authorities will adjust the policy dials just enough to stabilize growth sometime in the first half of 2019. The bottoming in China’s broad money impulse offers a ray of hope (Chart 16). Still, it is a tentative signal at best and it will take some time before this recent easing in monetary policy shows up in our credit impulse measure and, later, economic growth. A modest firming in Chinese growth in the second half of 2019 would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. Chart 16A Ray Of Hope From Broad Money bca.bca_mp_2018_12_01_c16 bca.bca_mp_2018_12_01_c16 Ms. X: If you are correct about a stabilization in the Chinese economy next year, this presumably would be good news for emerging economies, especially if the Fed goes on hold. EM assets have been terribly beaten down and I am looking for an opportunity to buy. BCA: Fed rate hikes might have been the catalyst for the past year’s pain in EM assets, but it is not the underlying problem. As we highlighted at last year’s meeting, the troubles for emerging markets run much deeper. Our long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Excessive debt is a ticking time bomb for many of these countries; EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart 17). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart 17, bottom panel). Chart 17EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... Decelerating global growth has exposed these poor fundamentals. EM sovereign spreads have moved wider in conjunction with falling PMIs and slowing industrial production and export growth. And it certainly does not help that the Fed is tightening dollar-based liquidity conditions. EM equities usually fall when U.S. financial conditions tighten (Chart 18). Chart 18...And Tightening Financial Conditions ...And Tightening Financial Conditions ...And Tightening Financial Conditions Chart 19 highlights the most vulnerable economies in terms of foreign currency funding requirements, and foreign debt-servicing obligations relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. In contrast, Emerging Asia appears to be in better shape relative to the crisis period of the late 1990s. Chart 19Spot The Outliers OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence The backdrop for EM assets is likely to get worse in the near term, given our view that the Fed will continue to tighten and China will be cautious about stimulating more aggressively. Our base case outlook sees some relief in the second half of 2019, but it is more of a “muddle-through” scenario than a V-shaped economic recovery. Mr. X: Perhaps EM assets could enjoy a bounce next year if the Chinese economy stabilizes, but the poor macro fundamentals you mentioned suggest that it would be a trade rather than a buy-and-hold proposition. I am inclined to avoid the whole asset class in 2019. Bond Market Prospects Ms. X: Let’s turn to fixed income now. I was bearish on bonds in 2018, but yields have risen quite a bit, at least in the United States. The Fed has lifted the fed funds rate by 100 basis points over the past year and I don’t see a lot of upside for inflation. So perhaps yields have peaked and will move sideways in 2019, which would be good for stocks in my view. BCA: Higher yields have indeed improved bond value recently. Nonetheless, they are not cheap enough to buy at this point (Chart 20). The real 10-year Treasury yield, at close to 1%, is still depressed by pre-Lehman standards. Long-term real yields in Germany and Japan remain in negative territory at close to the lowest levels ever recorded. Chart 20Real Yields Still Very Depressed Real Yields Still Very Depressed Real Yields Still Very Depressed We called the bottom in global nominal bond yields in 2016. Our research at the time showed that the cyclical and structural factors that had depressed yields were at an inflection point, and were shifting in a less bond-bullish direction. Perhaps most important among the structural factors, population aging and a downward trend in underlying productivity growth resulted in lower equilibrium bond yields over the past couple of decades. Looking ahead, productivity growth could stage a mild rebound in line with the upturn in the growth rate of the capital stock (Chart 21). As for demographics, the age structure of the world population is transitioning from a period in which aging added to the global pool of savings to one in which aging is beginning to drain that pool as people retire and begin to consume their nest eggs (Chart 22). The household saving rates in the major advanced economies should trend lower in the coming years, placing upward pressure on equilibrium global bond yields. Chart 21Productivity Still Has Some Upside Productivity Still Has Some Upside Productivity Still Has Some Upside Chart 22Demographics Past The Inflection Point Demographics Past The Inflection Point Demographics Past The Inflection Point Cyclical factors are also turning against bonds. U.S. inflation has returned to target and the Fed is normalizing short-term interest rates. The market currently is priced for only one more rate hike after December 2018 in this cycle, but we see rates rising more than that. Treasury yields will follow as market expectations adjust. Long-term inflation expectations are still too low in the U.S. and most of the other major economies to be consistent with central banks’ meeting their inflation targets over the medium term. As actual inflation edges higher, long-term expectations built into bond yields will move up. The term premium portion of long-term bond yields is also too low. This is the premium that investors demand to hold longer-term bonds. Our estimates suggest that the term premium is still negative in the advanced economies outside of the U.S., which is not sustainable over the medium term (Chart 23). Chart 23Term Premia Are Too Low Term Premia Are Too Low Term Premia Are Too Low We expect term premia to rise for two main reasons. First, investors have viewed government bonds as a good hedge for their equity holdings because bond prices have tended to rise when stock prices fell. Investors have been willing to pay a premium to hold long-term bonds to benefit from this hedging effect. But the correlation is now beginning to change as inflation and inflation expectations gradually adjust higher and output gaps close. As the hedging benefit wanes, the term premium should rise back into positive territory. Second, central bank bond purchases and forward guidance have depressed yields as well as interest-rate volatility. The latter helped to depress term premia in the bond market. This effect, too, is beginning to unwind. The Fed is letting its balance sheet shrink by about $50 billion per month. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB is about to end asset purchases. The Bank of Japan continues to buy assets, but at a much reduced pace. All this means that the private sector is being forced to absorb a net increase in government bonds for the first time since 2014 (Chart 24). Chart 25 shows that bond yields in the major countries will continue to trend higher as the rapid expansion of central bank balance sheets becomes a thing of the past. Chart 24Private Sector To Absorb More Bonds OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Chart 25QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices Ms. X: I’m not a fan of bonds at these levels, but that sounds overly bearish to me, especially given the recent plunge in oil prices. BCA: Lower oil prices will indeed help to hold down core inflation to the extent that energy prices leak into non-energy prices in the near term. Nonetheless, in the U.S., this effect will be overwhelmed by an overheated economy. From a long-term perspective, we believe that investors still have an overly benign view of the outlook for yields. The market expects that the 10-year Treasury yield in ten years will only be slightly above today’s spot yield, which itself is still very depressed by historical standards (Chart 26). And that also is the case in the other major bond markets. Chart 26Forward Yields Are Too Low Forward Yields Are Too Low Forward Yields Are Too Low Of course, it will not be a straight line up for yields – there will be plenty of volatility. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. Duration should be kept short at least until the middle of 2019, with an emphasis on TIPS relative to conventional Treasury bonds. We will likely downgrade TIPS versus conventionals once long-term inflation expectations move into our target range, which should occur sometime during 2019. The ECB and Japan will not be in a position to raise interest rates for some time, but the bear phase in U.S. Treasurys will drag up European and Japanese bond yields (at the very long end of the curve for the latter). Total returns are likely to be negative in all of the major bond markets in 2019. Real 10-year yields in all of the advanced economies are still well below their long-term average, except for Greece, Italy and Portugal (Chart 27). Chart 27Valuation Ranking Of Developed Bond Markets OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Within global bond portfolios, we recommend being underweight bond markets where central banks are in a position to raise short-term interest rates (the U.S. and Canada), and overweight those that are not (Japan and Australia). The first ECB rate hike is unlikely before the end of 2019. However, the imminent end of the asset purchase program argues for no more than a benchmark allocation to core European bond markets within global fixed-income portfolios, especially since real 10-year yields in parts of continental Europe are the furthest below their long-term average. We are overweight gilts at the moment, but foresee shifting to underweight in 2019, depending on how Brexit plays out. Ms. X: What about corporate bonds? I know that total returns for corporates will be poor if government bond yields are rising. But you recommended overweighting corporate bonds relative to Treasurys last year. Given your view that the next U.S. recession is more than a year away, it seems reasonable to assume they will outperform government bonds. BCA: We were overweight corporates in the first half of 2018, but took profits in June and shifted to neutral at the same time that we downgraded our equity allocation. Spreads had tightened to levels that did not compensate investors for the risks. Recent spread widening has returned some value to U.S. corporates. The 12-month breakeven spreads for A-rated and Baa-rated corporate bonds are almost back up to their 50th percentile relative to history (Chart 28). Still, these levels are not attractive enough to justify buying based on valuation alone. As for high-yield, any rise in the default rate would quickly overwhelm the yield pickup in this space. Chart 28Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside It is possible that some of the spread widening observed in October and November will reverse, but corporates offer a poor risk/reward tradeoff, even if the default rate stays low. Corporate profit growth is bound to decelerate in 2019. This would not be a disaster for equities, but slowing profit growth is more dangerous for corporate bond excess returns because the starting point for leverage is already elevated. As discussed above, at a macro level, the aggregate interest coverage ratio for the U.S. corporate sector is decent by historical standards. However, this includes mega-cap companies that have little debt and a lot of cash. Our bottom-up research suggests that interest coverage ratios for firms in the Bloomberg Barclays corporate bond index will likely drop close to multi-decade lows during the next recession, sparking a wave of downgrade activity and fallen angels. Seeing this coming, investors may require more yield padding to compensate for these risks as profit growth slows. Our next move will likely be to downgrade corporate bonds to underweight. We are watching the yield curve, bank lending standards, profit growth, and monetary indicators for signs to further trim exposure. You should already be moving up in quality within your corporate bond allocation. Mr. X: We have already shifted to underweight corporate bonds in our fixed income portfolio. Even considering the cheapening that has occurred over the past couple of months, spread levels still make no sense in terms of providing compensation for credit risk. Equity Market Outlook Ms. X: While we all seem to agree that corporate bonds are not very attractive, I believe that enough value has been restored to equities that we should upgrade our allocation, especially if the next recession is two years away. And I know that stocks sometimes have a powerful blow-off phase before the end of a bull market. Mr. X: This is where I vehemently disagree with my daughter. The recent sell-off resembles a bloodbath in parts of the global market. It has confirmed my worst fears, especially related to the high-flying tech stocks that I believe were in a bubble. Hopes for a blow-off phase are wishful thinking. I’m wondering if the sell-off represents the beginning of an extended bear market. BCA: Some value has indeed been restored. However, the U.S. market is far from cheap relative to corporate fundamentals. The trailing and 12-month forward price-earnings ratios (PER) of 20 and 16, respectively, are still far above their historical averages, especially if one leaves out the tech bubble period of the late 1990s. And the same is true for other metrics such as price-to-sales and price-to-book value (Chart 29). BCA’s composite valuation indicator, based on 8 different valuation measures, is only a little below the threshold of overvaluation at +1 standard deviation because low interest rates still favor equities on a relative yield basis. Chart 29U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap It is true that equities can reward investors handsomely in the final stage of a bull market. Chart 30 presents cumulative returns to the S&P 500 in the last nine bull markets. The returns are broken down by quintile. The greatest returns, unsurprisingly, generally occur in the first part of the bull market (quintile 1). But total returns in the last 20% of the bull phase (quintile 5) have been solid and have beaten the middle quartiles. Chart 30Late-Cycle Blow-Offs Can Be Rewarding OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Of course, the tricky part is determining where we are in the bull market. We have long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. The historical track record for risk assets is very clear; they tend to perform well when the fed funds rate is below neutral, whether rates are rising or falling. Risk assets tend to underperform cash when the fed funds rate is above neutral (Table 3). Table 3Stocks Do Well When The Fed Funds Rate Is Below Neutral OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence We believe the fed funds rate is still in easy territory. This suggests that it is too early to shift to underweight on risk assets. We may even want to upgrade to overweight if stocks become cheap enough, as long as Fed policy is not restrictive. That said, there is huge uncertainty about the exact level of rates that constitutes “neutral” (or R-star in the Fed’s lingo). Even the Fed is unsure. This means that we must watch for signs that the fed funds rate has crossed the line into restrictive territory as the FOMC tightens over the coming year. An inversion of the 3-month T-bill/10-year yield curve slope would be a powerful signal that policy has become tight, although the lead time of an inverted curve and declining risk asset prices has been quite variable historically. Finally, it is also important to watch U.S. profit margins. Some of our research over the past couple of years focused on the late-cycle dynamics of previous long expansions, such as the 1960s, 1980s and 1990s. We found that risk assets came under pressure once U.S. profit margins peaked. Returns were often negative from the peak in margins to the subsequent recession. Mr. X: U.S. profit margins must be close to peak levels. I’ve seen all sorts of anecdotal examples of rising cost pressures, not only in the labor market. BCA: We expected to see some margin pressure to appear by now. S&P 500 EPS growth will likely top out in the next couple of quarters, if only because the third quarter’s 26% year-over-year pace is simply not sustainable. But it is impressive that our margin proxies are not yet flagging an imminent margin squeeze, despite the pickup in wage growth (Chart 31). Chart 31U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat Margins according to the National Accounts (NIPA) data peaked in 2014 and have since diverged sharply with S&P 500 operating margins. It is difficult to fully explain the divergence. The NIPA margin is considered to be a better measure of underlying U.S. corporate profitability because it includes all companies (not just 500), and it is less subject to accounting trickery. That said, even the NIPA measure of margins firmed a little in 2018, along with the proxies we follow that correlate with the S&P 500 measure. The bottom line is that the macro variables that feed into our top-down U.S. EPS model point to a continuing high level of margins and fairly robust top-line growth, at least for the near term. For 2019, we assumed slower GDP growth and incorporated some decline in margins into our projection just to err on the conservative side. Nonetheless, our EPS model still projects a respectable 8% growth rate at the end of 2019 (Chart 32). The dollar will only be a minor headwind to earnings growth unless it surges by another 10% or more. Chart 32EPS Growth Forecasts EPS Growth Forecasts EPS Growth Forecasts The risks to EPS growth probably are to the downside relative to our forecast, but the point is that U.S. earnings will likely remain supportive for the market unless economic growth is much weaker than we expect. None of this means that investors should be aggressively overweight stocks now. We trimmed our equity recommendation to benchmark in mid-2018 for several reasons. At the time, value was quite poor and bottom-up earnings expectations were too high, especially on a five-year horizon. Also, sentiment measures suggested that investors were overly complacent. As you know, we are always reluctant to chase markets into highly overvalued territory, especially when a lot of good news has been discounted. As we have noted, we are open to temporarily shifting back to overweight in equities and other risk assets. The extension of the economic expansion gives more time for earnings to grow. The risks facing the market have not eased much but, given our base-case macro view, we would be inclined to upgrade equities if there is another meaningful correction. Of course, our profit, monetary and economic indicators would have to remain supportive to justify an upgrade. Mr. X: But you are bearish on bonds. We saw in October that the equity market is vulnerable to higher yields. BCA: It certainly won’t be smooth sailing through 2019 as interest rates normalize. Until recently, higher bond yields reflected stronger growth without any associated fears that inflation was a growing problem. The ‘Fed Put’ was seen as a key backstop for the equity bull market. But now that the U.S. labor market is showing signs of overheating, the bond sell-off has become less benign for stocks because the Fed will be less inclined to ease up at the first sign of trouble in the equity market. How stocks react in 2019 to the upward trend in yields depends a lot on the evolution of actual inflation and long-term inflation expectations. If core PCE inflation hovers close to or just above 2% for a while, then the Fed Put should still be in place. However, it would get ugly for both bonds and stocks if inflation moves beyond 2.5%. Our base case is that this negative dynamic won’t occur until early 2020, but obviously the timing is uncertain. One key indicator to watch is long-term inflation expectations, such as the 10-year TIPS breakeven inflation rate (Chart 33). It is close to 2% at the moment. If it shifts up into the 2.3%-2.5% range, it would confirm that inflation expectations have returned to a level that is consistent with the Fed meeting its 2% inflation target on a sustained basis. This would be a signal to the Fed that it is must become more aggressive in calming growth, with obvious negative consequences for risk assets. Chart 33Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Mr. X: I am skeptical that the U.S. corporate sector can pull off an 8% earnings gain in 2019. What about the other major markets? Won’t they get hit hard if global growth continues to slow as you suggest? BCA: Yes, that is correct. It is not surprising that EPS growth has already peaked in the Euro Area and Japan. The profit situation is going to deteriorate quickly in the coming quarters. Industrial production growth in both economies has already dropped close to zero, and we use this as a proxy for top-line growth in our EPS models. Nominal GDP growth has decelerated sharply in both economies in absolute terms and relative to the aggregate wage bill. These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our models. Both the Euro Area and Japanese equity markets are cheap relative to the U.S., based on our composite valuation indicators (Chart 34). However, neither is above the threshold of undervaluation (+1 standard deviation) that would justify overweight positions on valuation alone. We think the U.S. market will outperform the other two at least in the first half of 2019 in local and, especially, common-currency terms. Chart 34Valuation Of Nonfinancial Equity Markets Relative To The U.S. OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: It makes sense that U.S. profit growth will outperform the other major developed countries in 2019. I would like to circle back to emerging market assets. I understand that many emerging economies have deep structural problems. But you admitted that the Chinese authorities will eventually stimulate enough to stabilize growth, providing a bounce in EM growth and asset prices next year. These assets seem cheap enough to me to warrant buying now in anticipation of that rally. As we all know, reversals from oversold levels can happen in a blink of an eye and I don’t want to miss it. BCA: We are looking for an opportunity to buy as well, but are wary of getting in too early. First, valuation has improved but is not good enough on its own to justify buying now. EM stocks are only moderately undervalued based on our EM composite valuation indicator and the cyclically-adjusted P/E ratio (Chart 35). EM currencies are not particularly cheap either, outside of Argentina, Turkey and Mexico (Charts 36A and 36B). Valuation should only play a role in investment strategy when it is at an extreme, and this is not the case for most EM countries. Chart 35EM Stocks Are Not At Capitulation Levels... bca.bca_mp_2018_12_01_c35 bca.bca_mp_2018_12_01_c35   Chart 36A…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Chart 36B…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Second, corporate earnings growth has plenty of downside potential in the near term. Annual growth in EM nonfinancial EBITDA, currently near 10%, is likely to turn negative next year, based on our China credit and fiscal impulse indicator (Chart 37). And, as we emphasized earlier, China is not yet pressing hard on the gas pedal. Chart 37EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside Third, it will take time for more aggressive Chinese policy stimulus, if it does occur, to show up in EM stocks and commodity prices. Trend changes in money growth and our credit and fiscal impulse preceded the trough in EM stocks and commodity prices in 2015, and again at the top in stocks and commodities in 2017 (Chart 38). However, even if these two indicators bottom today, it could take several months before the sell-off in EM financial markets and commodity prices abates. Chart 38Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Finally, if Chinese stimulus comes largely via easier monetary policy rather than fiscal stimulus, then the outcome will be a weaker RMB. We expect the RMB to drift lower in any event, because rate differentials vis-à-vis the U.S. will move against the Chinese currency next year. A weaker RMB would add to the near-term headwinds facing EM assets. The bottom line is that the downside risks remain high enough that you should resist the temptation to bottom-fish until there are concrete signs that the Chinese authorities are getting serious about boosting the economy. We are also watching for signs outside of China that the global growth slowdown is ending. This includes our global leading economic indicator and data that are highly sensitive to global growth, such as German manufacturing foreign orders. Mr. X: Emerging market assets would have to become a lot cheaper for me to consider buying. Debt levels are just too high to be sustained, and stronger Chinese growth would only provide a short-term boost. I’m not sure I would even want to buy developed market risk assets based solely on some Chinese policy stimulus. BCA: Yes, we agree with your assessment that buying EM in 2019 would be a trade rather than a buy-and-hold strategy. Still, the combination of continued solid U.S. growth and a modest upturn in the Chinese economy would alleviate a lot of investors’ global growth concerns. The result could be a meaningful rally in pro-cyclical assets that you should not miss. We are defensively positioned at the moment, but we could see becoming more aggressive in 2019 on signs that China is stimulating more firmly and/or our global leading indicators begin to show some signs of life. Besides upgrading our overall equity allocation back to overweight, we would dip our toes in the EM space again. At the same time, we will likely upgrade the more cyclical DM equity markets, such as the Euro Area and Japan, while downgrading the defensive U.S. equity market to underweight. We are currently defensively positioned in terms of equity sectors, but it would make sense to shift cyclicals to overweight at the same time. Exact timing is always difficult, but we expect to become more aggressive around the middle of 2019. We also think the time is approaching to favor long-suffering value stocks over growth stocks. The relative performance of growth-over-value according to standard measures has become a sector call over the past decade: tech or financials. The sector skew complicates this issue, especially since tech stocks have already cracked. But we have found that stocks that are cheap within equity sectors tend to outperform expensive (or growth) stocks once the fed funds rate moves into restrictive territory. This is likely to occur in the latter half of 2019. Value should then have its day in the sun. Currencies: Mr. X: We don’t usually hedge our international equity exposure, so the direction of the dollar matters a lot to us. As you predicted a year ago, the U.S. dollar reigned supreme in 2018. Your economic views suggest another good year in 2019, but won’t this become a problem for the economy? President Trump’s desire to lower the U.S. trade deficit suggests that the Administration would like the dollar to drop and we could get some anti-dollar rhetoric from the White House. Also, it seems that the consensus is strongly bullish on the dollar which is always a concern. BCA: The outlook for the dollar is much trickier than it was at the end of 2017. As you highlighted, traders are already very long the dollar, implying that the hurdle for the greenback to surprise positively is much higher now. However, a key driver for the dollar is the global growth backdrop. If the latter is poor in the first half of 2019 as we expect, it will keep a bid under the greenback. Interest rates should also remain supportive for the dollar. As we argued earlier, current market expectations – only one more Fed hike after the December meeting – are too sanguine. If the Fed increases rates by more than currently discounted, the dollar’s fair value will rise, especially if global growth continues to lag that of the U.S. Since the dollar’s 2018 rally was largely a correction of its previous undervaluation, the currency has upside potential in the first half of the year (Chart 39). Chart 39U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued A stronger dollar will dampen foreign demand for U.S.-produced goods and will boost U.S. imports. However, do not forget that a rising dollar benefits U.S. consumers via its impact on import prices. Since the consumer sector represents 68% of GDP, and that 69% of household consumption is geared toward the (largely domestic) service sector, a strong dollar will not be as negative for aggregate demand and employment as many commentators fear, unless it were to surge by at least another 10%. In the end, the dollar will be more important for the distribution of U.S. growth than its overall level. Where the strong dollar is likely to cause tremors is in the political arena. You are correct to point out that there is a large inconsistency between the White House’s desires to shore up growth, while simultaneously curtailing the trade deficit, especially if the dollar appreciates further. As long as the Fed focuses on its dual mandate and tries to contain inflationary pressures, the executive branch of the U.S. government can do little to push the dollar down. Currency intervention cannot have a permanent effect unless it is accompanied by shifts in relative macro fundamentals. For example, foreign exchange intervention by the Japanese Ministry of Finance in the late 1990s merely had a temporary impact on the yen. The yen only weakened on a sustained basis once interest rate differentials moved against Japan. This problem underpins our view that the Sino-U.S. relationship is unlikely to improve meaningfully next year. China will remain an easy target to blame for the U.S.’s large trade deficit. What ultimately will signal a top in the dollar is better global growth, which is unlikely until the second half of 2019. At that point, expected returns outside the U.S. will improve, causing money to leave the U.S., pushing the dollar down. Mr. X: While 2017 was a stellar year for the euro, 2018 proved a much more challenging environment. Will 2019 be more like 2017 or 2018? BCA: We often think of the euro as the anti-dollar; buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, the activity gap between the U.S. and the Euro Area continues to move in a euro-bearish fashion (Chart 40). Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread still points toward a weaker euro. Chart 40Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro It is important to remember that when Chinese economic activity weakens, European growth deteriorates relative to the U.S. Thus, our view that global growth will continue to sputter in the first half of 2019 implies that the monetary policy divergence between the Fed and the ECB has not yet reached a climax. Consequently, we expect EUR/USD to trade below 1.1 in the first half of 2019. By that point, the common currency will be trading at a meaningful discount to its fair value, which will allow it to find a floor (Chart 41). Chart 41Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Mr. X: The Bank of Japan has debased the yen, with a balance sheet larger than Japan’s GDP. This cannot end well. I am very bearish on the currency. BCA: The BoJ’s monetary policy is definitely a challenge for the yen. The Japanese central bank rightfully understands that Japan’s inability to generate any meaningful inflation – despite an economy that is at full employment – is the consequence of a well-established deflationary mindset. The BoJ wants to shock inflation expectations upward by keeping real rates at very accommodative levels well after growth has picked up. This means that the BoJ will remain a laggard as global central banks move away from accommodative policies. The yen will continue to depreciate versus the dollar as U.S. yields rise on a cyclical horizon. That being said, the yen still has a place within investors’ portfolios. First, the yen is unlikely to collapse despite the BoJ’s heavy debt monetization. The JPY is one of the cheapest currencies in the world, with its real effective exchange rate hovering at a three-decade low (Chart 42). Additionally, Japan still sports a current account surplus of 3.7% of GDP, hardly the sign of an overstimulated and inflationary economy where demand is running amok. Instead, thanks to decades of current account surpluses, Japan has accumulated a positive net international investment position of 60% of GDP. This means that Japan runs a constant and large positive income balance, a feature historically associated with strong currencies. Chart 42The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Japan’s large net international investment position also contributes to the yen’s defensive behavior as Japanese investors pull money back to safety at home when global growth deteriorates. Hence, the yen could rebound, especially against the euro, the commodity currencies, and EM currencies if there is a further global growth scare in the near term. Owning some yen can therefore stabilize portfolio returns during tough times. As we discussed earlier, we would avoid the EM asset class, including currency exposure, until global growth firms. Commodities: Ms. X: Once again, you made a good call on the energy price outlook a year ago, with prices moving higher for most of the year. But the recent weakness in oil seemed to come out of nowhere, and I must admit to being confused about where we go next. What are your latest thoughts on oil prices for the coming year? BCA: The fundamentals lined up in a very straightforward way at the end of 2017. The coalition we have dubbed OPEC 2.0 – the OPEC and non-OPEC producer group led by the Kingdom of Saudi Arabia (KSA) and Russia – outlined a clear strategy to reduce the global oil inventory overhang. The producers that had the capacity to increase supply maintained strict production discipline which, to some analysts, was still surprising even after the cohesiveness shown by the group in 2017. Outside that core group output continued to fall, especially in Venezuela, which remains a high-risk producing province. The oil market was balanced and prices were slowly moving higher as we entered the second quarter of this year, when President Trump announced the U.S. would re-impose oil export sanctions against Iran beginning early November. The oft-repeated goal of the sanctions was to reduce Iranian exports to zero. To compensate for the lost Iranian exports, President Trump pressured OPEC, led by KSA, to significantly increase production, which they did. However, as we approached the November deadline, the Trump Administration granted the eight largest importers of Iranian oil 180-day waivers on the sanctions. This restored much of the oil that would have been lost. Suddenly, the market found itself oversupplied and prices fell. As we move toward the December 6 meeting of OPEC 2.0 in Vienna, we are expecting a production cut from the coalition of as much as 1.4mm b/d to offset these waivers. The coalition wishes to keep global oil inventories from once again over-filling and dragging prices even lower in 2019. On the demand side, consumption continues to hold up both in the developed and emerging world, although we have somewhat lowered our expectations for growth next year. We are mindful of persistent concerns over the strength of demand – particularly in EM – in 2019. Thus, on the supply side and the demand side, the level of uncertainty in the oil markets is higher than it was at the start of 2018. Nonetheless, our base-case outlook is on the optimistic side for oil prices in 2019, with Brent crude oil averaging around $82/bbl, and WTI trading $6/bbl below that level (Chart 43). Chart 43Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Ms. X: I am skeptical that oil prices will rebound as much as you expect. First, oil demand is likely to falter if your view that global growth will continue slowing into early 2019 proves correct. Second, U.S. shale production is rising briskly, with pipeline bottlenecks finally starting to ease. Third, President Trump seems to have gone from taking credit for high equity prices to taking credit for low oil prices. Trump has taken a lot flack for supporting Saudi Arabia following the killing of The Washington Post journalist in Turkey. Would the Saudis really be willing to lose Trump’s support by cutting production at this politically sensitive time? BCA: Faltering demand growth remains a concern. However, note that in our forecasts we do expect global oil consumption growth to slow down to 1.46mm b/d next year, somewhat lower than the 1.6mm b/d growth we expect this year.  In terms of the U.S. shale sector, production levels over the short term can be somewhat insensitive to changes in spot and forward prices, given the hedging activity of producers. Over the medium to longer term, however, lower spot and forward prices will disincentivize drilling by all but the most efficient producers with the best, lowest-cost acreage. If another price collapse were to occur – and were to persist, as the earlier price collapse did – we would expect a production loss of between 5% and 10% from the U.S. shales.  Regarding KSA, the Kingdom needs close to $83/bbl to balance its budget this year and next, according to the IMF’s most recent estimates. If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. President Trump’s insistence on higher production from KSA and the rest of OPEC is a non-starter – it would doom those economies to recession, and stifle further investment going forward. The U.S. would also suffer down the road, as the lack of investment significantly tightens global supply. So, net, if production cuts are not forthcoming from OPEC at its Vienna meeting we – and the market – will be downgrading our oil forecast. Ms. X: Does your optimism regarding energy extend to other commodities? The combination of a strong dollar and a China slowdown did a lot of damage to industrial commodities in 2018. Given your view that China’s economy should stabilize in 2019, are we close to a bottom in base metals? BCA: It is too soon to begin building positions in base metals because the trade war is going to get worse before it gets better. Exposure to base metals should be near benchmark at best entering 2019, although we will be looking to upgrade along with other risk assets if Chinese policy stimulus ramps up. Over the medium term, the outlook for base metals hinges on how successfully China pulls off its pivot toward consumer- and services-led growth, away from heavy industrial-led development. China accounts for roughly half of global demand for these base metals. Commodity demand from businesses providing consumer goods and services is lower than that of heavy industrial export-oriented firms. But demand for commodities used in consumer products – e.g., copper, zinc and nickel, which go into stainless-steel consumer appliances such as washers and dryers – will remain steady, and could increase if the transition away from heavy industrial-led growth is successful. Gasoline and jet fuel demand will also benefit, as EM consumers’ demand for leisure activities such as tourism increases with rising incomes. China is also going to be a large producer and consumer of electric vehicles, as it attempts to reduce its dependence on imported oil. Although timing the production ramp-up is difficult, in the long term these trends will be supportive for nickel and copper. Mr. X: You know I can’t let you get away without asking about gold. The price of bullion is down about 5% since the end of 2017, but that is no worse than the global equity market and it did provide a hedge against economic, financial or political shocks. The world seems just as risky as it did a year ago, so I am inclined to hold on to our gold positions, currently close to 10% of our portfolio. That is above your recommended level, but keeping a solid position in gold is one area where my daughter and I have close agreement regarding investment strategy. BCA: Gold did perform well during the risk asset corrections we had in 2018, and during the political crises as well. The price is not too far away from where we recommended going long gold as a portfolio hedge at the end of 2017 ($1230.3/oz). We continue to expect gold to perform well as a hedge. When other risk assets are trading lower, gold holds value relative to equities and tends to outperform bonds (Chart 44). Likewise, when other risk assets are rising, gold participates, but does not do as well as equities. It is this convexity – outperforming on the downside but participating on the upside with other risk assets – that continues to support our belief that gold has a role as a portfolio hedge. However, having 10% of your portfolio in gold is more than we would recommend – we favor an allocation of around 5%. Chart 44Hold Some Gold As A Hedge OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Geopolitics Ms. X: I’m glad that the three of us agree at least on one thing – hold some gold! Let’s return to the geopolitical situation for a moment. Last year, you correctly forecast that divergent domestic policies in the U.S. and China – stimulus in the former and lack thereof in the latter – would be the most investment-relevant geopolitical issue. At the time, I found this an odd thing to highlight, given the risks of protectionism, populism, and North Korea. Do you still think that domestic policies will dominate in 2019? BCA: Yes, policy divergence between the U.S. and China will also dominate in 2019, especially if it continues to buoy the U.S. economy at the expense of the rest of the world. Of course, Beijing may decide to do more stimulus to offset its weakening economy and the impact of the trade tariffs. A headline rate cut, cuts to bank reserve requirements, and a boost to local government infrastructure spending are all in play. In the context of faltering housing and capex figures in the U.S., the narrative over the next quarter or two could be that the policy divergence is over, that Chinese policymakers have “blinked.” We are pushing back against this narrative on a structural basis. We have already broadly outlined our view that China will not be pressing hard to boost demand growth. Many of its recent policy efforts have focused on rebalancing the economy away from debt-driven investment (Chart 45). The problem for the rest of the world is that raw materials and capital goods comprise 85% of Chinese imports. As such, efforts to boost domestic consumption will have limited impact on the rest of the world, especially as emerging markets are highly leveraged to “old China.” Chart 45Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Meanwhile, the Trump-Democrat gridlock could yield surprising results in 2019. President Trump is becoming singularly focused on winning re-election in 2020. As such, he fears the “stimulus cliff” looming over the election year. Democrats, eager to show that they are not merely the party of “the Resistance,” have already signaled that an infrastructure deal is their top priority. With fiscal conservatives in the House all but neutered by the midterm elections, a coalition between Trump and likely House Speaker Nancy Pelosi could emerge by late 2019, ushering in even more fiscal stimulus. While the net new federal spending will not be as grandiose as the headline figures, it will be something. There will also be regular spending increases in the wake of this year’s bipartisan removal of spending caps. We place solid odds that the current policy divergence narrative continues well into 2019, with bullish consequences for the U.S. dollar and bearish outcomes for EM assets, at least in the first half of the year. Mr. X: Your geopolitical team has consistently been alarmist on the U.S.-China trade war, a view that bore out throughout 2018. You already stated that you think trade tensions will persist in 2019. Where is this heading? BCA: Nowhere good. Rising geopolitical tensions in the Sino-American relationship has been our premier geopolitical risk since 2012. The Trump administration has begun tying geopolitical and strategic matters in with the trade talks. No longer is the White House merely asking for a narrowing of the trade deficit, improved intellectual property protections, and the removal of non-tariff barriers to trade. Now, everything from surface-to-air missiles in the South China Sea to Beijing’s “Belt and Road” project are on the list of U.S. demands. Trade negotiations are a “two-level game,” whereby policymakers negotiate in parallel with their foreign counterparts and domestic constituents. While Chinese economic agents may accept U.S. economic demands, it is not clear to us that its military and intelligence apparatus will accept U.S. geopolitical demands. And Xi Jinping himself is highly attuned to China’s geopolitical position, calling for national rejuvenation above all. We would therefore downplay any optimistic news from the G20 summit between Presidents Trump and Xi. President Trump could freeze tariffs at current rates and allow for a more serious negotiating round throughout 2019. But unless China is willing to kowtow to America, a fundamental deal will remain elusive in the end. For Trump, a failure to agree is still a win domestically, as the median American voter is not asking for a resolution of the trade war with China (Chart 46). Chart 46Americans Favor Being Tough On China OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Could trade tensions spill into rising military friction? BCA: Absolutely. Minor military skirmishes will likely continue and could even escalate. We believe that there is a structural bull market in “war.” Investors should position themselves by being long global defense stocks. Mr. X: That is not encouraging. What about North Korea and Iran? Could they become geopolitical risks in 2019? BCA: Our answer to the North Korea question remains the same as 12 months ago: we have seen the peak in the U.S.’ display of a “credible military threat.” But Iran could re-emerge as a risk mid-year. We argued in last year’s discussion that President Trump was more interested in playing domestic politics than actually ratcheting up tensions with Iran. However, in early 2018 we raised our alarm level, particularly when staffing decisions in the White House involved several noted Iran hawks joining the foreign policy team. This was a mistake. Our initial call was correct, as President Trump ultimately offered six-month exemptions to eight importers of Iranian crude. That said, those exemptions will expire in the spring. The White House may, at that point, ratchet up tensions with Iran. This time, we will believe it when we see it. Intensifying tensions with Iran ahead of the U.S. summer vacation season, and at a time when crude oil markets are likely to be finely balanced, seems like folly, especially with primary elections a mere 6-to-8 months away. What does President Trump want more: to win re-election or to punish Iran? We think the answer is obvious, especially given that very few voters seem to view Iran as the country’s greatest threat (Chart 47). Chart 47Americans Don’t See Iran As A Major Threat OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Let’s turn to Europe. You have tended to dismiss Euroskeptics as a minor threat, which has largely been correct. But don’t you think that, with Brexit upon us and Chancellor Angela Merkel in the twilight, populism in continental Europe will finally have its day? BCA: Let’s first wait to see how Brexit turns out! The next few months will be critical. Uncertainty is high, with considerable risks remaining. We do not think that Prime Minister May has the votes in the House of Commons to push through any version of soft Brexit that she has envisioned thus far. If the vote on the U.K.-EU exit deal falls through, a new election could be possible. This will require an extension of the exit process under Article 50 and a prolonged period of uncertainty. The probability of a no-deal Brexit is lower than 10%. It is simply not in the interest of anyone involved, save for a smattering of the hardest of hard Brexit adherents in the U.K. Conservative Party. Put simply, if the EU-U.K. deal falls through in the House of Commons, or even if PM May is replaced by a hard-Brexit Tory, the most likely outcome is an extension of the negotiation process. This can be easily done and we suspect that all EU member states would be in favor of such an extension given the cost to business sentiment and trade that would result from a no-deal Brexit. It is not clear that Brexit has emboldened Euroskeptics. In fact, most populist parties in the EU have chosen to tone down their Euroskepticism and emphasize their anti-immigrant agenda since the Brexit referendum. In part, this decision has to do with how messy the Brexit process has become. If the U.K. is struggling to unravel the sinews that tie it to Europe, how is any other country going to fare any better? The problem for Euroskeptic populists is that establishment parties are wise to the preferences of the European median voter. For example, we now have Friedrich Merz, a German candidate for the head of the Christian Democratic Union – essentially Merkel’s successor – who is both an ardent Europhile and a hardliner on immigration. This is not revolutionary. Merz simply read the polls correctly and realized that, with 83% of Germans supporting the euro, the rise of the anti-establishment Alternative for Germany (AfD) is more about immigration than about the EU. As such, we continue to stress that populism in Europe is overstated. In fact, we expect that Germany and France will redouble their efforts to reform European institutions in 2019. The European parliamentary elections in May will elicit much handwringing by the media due to a likely solid showing by Euroskeptics, even though the election is meaningless. Afterwards, we expect to see significant efforts to complete the banking union, reform the European Stability Mechanism, and even introduce a nascent Euro Area budget. But these reforms will not be for everyone. Euroskeptics in Central and Eastern Europe will be left on the outside looking in. Brussels may also be emboldened to take a hard line on Italy if institutional reforms convince the markets that the core Euro Area is sheltered from contagion. In other words, the fruits of integration will be reserved for those who play by the Franco-German rules. And that could, ironically, set the stage for the unraveling of the European Union as we know it. Over the long haul, a much tighter, more integrated, core could emerge centered on the Euro Area, with the rest of the EU becoming stillborn. The year 2019 will be a vital one for Europe. We are sensing an urgency in Berlin and Paris that has not existed throughout the crisis, largely due to Merkel’s own failings as a leader. We remain optimistic that the Euro Area will survive. However, there will be fireworks. Finally, a word about Japan. The coming year will see the peak of Prime Minister Shinzo Abe’s career. He is promoting the first-ever revision to Japan’s post-war constitution in order to countenance the armed forces. If he succeeds, he will have a big national security success to couple with his largely effective “Abenomics” economic agenda – after that, it will all be downhill. If he fails, he will become a lame duck. This means that political uncertainty will rise in 2019, after six years of unusual tranquility. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground and your views have reinforced my belief that 2019 could be even more turbulent for financial markets than the past has been. I accept your opinion that a major global economic downturn is not around the corner, but with valuations still stretched, I feel that it makes good sense to focus on capital preservation. I may lose out on the proverbial “blow-off” rally, but so be it – I have been in this business long enough to know that it is much better to leave the party while the music is still playing! Ms. X: I agree with my father that the risks surrounding the outlook have risen as we have entered the late stages of this business-cycle expansion. Yet, if global growth does temporarily stabilize and corporate earnings continue to expand, I fear that being out of the market will be very painful. The era of hyper-easy money may be ending, but interest rates globally are still nowhere near restrictive territory. This tells me that the final stages of this bull market could be very rewarding. A turbulent market is not only one where prices go down – they can also go up a lot! BCA: The debate you are having is one we ourselves have had on numerous occasions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term returns. While most assets have cheapened over the past year, prices are still fairly elevated. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.9% over the next ten years, or 2.8% after adjusting for inflation. That is an improvement over our inflation-adjusted estimate of 1.3% from last year, but still well below the 6.6% real return that a balanced portfolio earned between 1982 and 2018. Table 410-Year Asset Return Projections OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Our return calculations for equities assume that profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if underlying changes in the economy keep corporate profits elevated as a share of GDP. Structurally lower real interest rates may also justify higher P/E multiples, although this would be largely offset by the prospect of slower economic growth, which will translate into slower earnings growth. In terms of the outlook for the coming year, a lot hinges on our view that monetary policy in the main economies stays accommodative. This seems like a safe assumption in the Euro Area and Japan, where rates are near historic lows, as well as in China, where the government is actively loosening monetary conditions. It is not such a straightforward conclusion for the U.S., where the Fed is on track to keep raising rates. If it turns out that the neutral interest rate is not far above where rates are already, we could see a broad-based slowdown of the U.S. economy that ripples through to the rest of the world. And even if U.S. monetary policy does remain accommodative, many things could still upset the apple cart, including a full-out trade war, debt crises in Italy or China, or a debilitating spike in oil prices. As the title of our outlook implies, 2019 is likely to be a year of increased turbulence. Ms. X: As always, you have left us with much to think about. My father has looked forward to these discussions every year and now that I am able to join him, I understand why. Before we conclude, it would be helpful to have a recap of your key views. BCA: That would be our pleasure. The key points are as follows: The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the willingness of the Fed to pause hiking rates even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reform agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of the sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply-side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s target of 2%, stocks will begin to buckle. This means that a window exists next year where stocks will outperform bonds. We would maintain a benchmark allocation to stocks for now, but increase exposure if global bourses were to fall significantly from current levels without a corresponding deteriorating in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely as long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 26, 2018 ​​​​​​

Highlights Credit: Credit spreads are widening due to the combination of weakening global growth and perceptions of restrictive Fed policy. Investors should monitor the indicators of global growth and Fed policy outlined in this report to call the peak in spreads. Duration: Financial conditions have not yet tightened enough for the Fed to take a significant dovish turn. Meanwhile, the housing market indicators with the best track records at signaling restrictive monetary policy remain benign. Maintain below-benchmark duration. MBS: Negative excess MBS returns during the past two months are the result of wider option-adjusted spreads, but continued easing in bank lending standards should prevent OAS from widening dramatically. Maintain a neutral allocation to MBS for now, but look to upgrade at the expense of corporate bonds as the credit cycle progresses. Feature The sell-off in credit markets continues to worsen. The average spread of the Bloomberg Barclays High-Yield index is now above 400 bps and the investment grade spread is at its widest level in two years (Chart 1). Chart 1Risk Off In Credit Markets Risk Off In Credit Markets Risk Off In Credit Markets Just like when credit markets sold off in 2014/15, the catalyst for wider spreads is the combination of weakening global economic growth and tight Fed policy. While indicators of global economic growth are sending negative signals, the Fed continues to focus on the sturdier domestic economy. Once again, the end result is a stronger dollar and a sell-off in risk assets.1 In the midst of a downturn, the relevant investment question becomes when to step back into the market. In this case, the question is: How should we go about calling the peak in credit spreads? In this week’s report we identify several catalysts that could signal a peak in credit spreads in the coming months. The catalysts fall into two categories: Signals of rebounding global growth Signals of Fed capitulation We consider each category in turn. Catalyst 1: Global Growth Rebound Chart 2 shows three indicators of global growth that investors should watch closely in the current environment. All three indicators are highly levered to global demand, signaled the peak in credit spreads in early 2016, and most importantly, are updated daily making it possible to track them in real time. Chart 2Signals Of Rebounding Global Growth Signals Of Rebounding Global Growth Signals Of Rebounding Global Growth The first indicator is the CRB Raw Industrials index (Chart 2, panel 2). This index troughed several weeks before the early-2016 peak in credit spreads. It is also currently in an uptrend, albeit a very modest one. The second indicator is the BCA Market-Based China Growth Indicator (Chart 2, panel 3). This indicator was created by our China Investment Strategy team as a broad proxy of investor expectations for Chinese growth.2 It includes 17 different market prices, spanning equity, commodity, fixed income and currency markets. Just like the CRB Raw Industrials index, it also signaled the early-2016 peak in credit spreads and is currently in a shallow uptrend. The third indicator is the price of Global Industrials stocks (Chart 2, bottom panel). These stocks also bottomed in early-2016, and they are currently trending down. On balance, we do not see sufficient evidence from these three indicators to call the peak in credit spreads. Global industrial stocks are collapsing, while the Raw Industrials and China Growth indexes have only put in tentative bottoms. Further, our assessment of economic trends suggests that these indicators may have more near-term downside. Weakness in global demand has largely been a function of slowing growth in China (Chart 3). The Chinese Manufacturing PMI has already collapsed to the 50 boom/bust line and we are still waiting to see the full impact of tariffs in the economic data. It’s true that Chinese policymakers have begun to ease monetary policy: interest rates are lower (Chart 3, panel 3) and the trade-weighted RMB has depreciated (Chart 3, bottom panel). But so far, easier monetary conditions have not passed through to the money and credit growth indicators that tend to lead Chinese economic activity. Our China Investment Strategy team’s Li Keqiang Leading Indicator is an index designed to lead the Li Keqiang index – a widely followed indicator of Chinese economic activity. The leading index is primarily composed of money and credit growth data, and it remains well below the zero line, pointing to further economic weakness ahead (Chart 3, panel 2). Chart 3Keep An Eye On China Keep An Eye On China Keep An Eye On China Catalyst 2: Fed Capitulation If global demand does not improve, then eventually financial conditions will tighten so much that the Fed will downgrade its assessment of future U.S. economic growth and adopt a more dovish policy stance. This is what happened in early 2016, and the Fed’s capitulation signaled the peak in credit spreads at that time (Chart 4). Chart 4Signals Of Fed Capitulation Signals Of Fed Capitulation Signals Of Fed Capitulation Our 12-month Fed Funds discounter tracks the market’s expectation for changes in the fed funds rate during the next 12 months. The discounter plunged sharply in early 2016 from a peak of 75 bps to a trough of 4 bps, signaling the peak in credit spreads (Chart 4, panel 2). At present, the discounter has fallen somewhat during the past few weeks, but hardly by enough to signal capitulation from the Fed on its “gradual” rate hike cycle. The minutes from the November FOMC meeting will be released this week and we will read closely to get a sense for how the Fed is thinking about the current state of financial conditions. However, at this point we view a December rate hike as a done deal. If credit spreads continue to widen between now and the December 19 FOMC meeting, then Chairman Powell’s post-meeting press conference will become critical for markets. Another useful indicator for the perceived stance of monetary policy is the price of gold (Chart 4, panel 3). In prior research we discussed why a higher gold price correlates with perceptions of easier monetary policy, and vice-versa.3 So it should not be surprising that gold rose sharply as the Fed capitulated in early 2016, signaling the peak in credit spreads. Gold has been range-bound during the past few weeks, but a significant upside break-out would signal a potential buying opportunity in credit. Finally, the trade-weighted U.S. dollar will likely be another useful indicator for calling the peak in credit spreads (Chart 4, bottom panel). The dollar is not a pure indicator of the stance of Fed policy like our 12-month discounter or the gold price. Rather, the dollar’s value is determined jointly by the outlooks for the U.S. economy and the rest of the world. However, a peak in the dollar would signal that either the Fed has become more dovish, or that non-U.S. growth has recovered significantly. Credit spreads would benefit in either case. The dollar did in fact roll over prior to the peak in credit spreads in early 2016, and we expect it would do the same again. Thus far we have focused on what to monitor to call the peak in credit spreads. One of the catalysts is an easing of Fed policy that would obviously be accompanied by lower Treasury yields. Therefore, it is worth thinking about how the outlook for credit spreads influences our portfolio duration call, and vice-versa. Chart 5 provides a useful illustration to help us think about the relationship. The chart shows our 12-month Fed Funds Discounter, our BCA Fed Monitor and each its three components lined up with the 2014/15 period. Specifically, this year’s trough in the dollar is lined up with the 2014 dollar trough, denoted in the chart by a vertical line. Chart 5BCA Fed Monitor: Today Vs. 2014/2015 BCA Fed Monitor: Today Vs. 2014/2015 BCA Fed Monitor: Today Vs. 2014/2015 The first key takeaway is that the market expects roughly the same number of rate hikes during the next 12 months as it did this far into the 2014/15 episode of dollar strength (Chart 5, top panel). However, our Fed Monitor is currently well above the zero line, suggesting that further rate hikes are warranted. This far into the 2014/15 dollar uptrend, our Fed Monitor had already dipped below zero (Chart 5, panel 2). The reason for today’s higher Fed Monitor is that U.S. economic growth and inflation are both on much firmer footing than during 2014/15 (Chart 5, panels 3 & 4). In fact, financial conditions have tightened more severely than at a similar stage of the 2014/15 episode, but the impact on the overall Monitor has been offset by stronger economic growth and inflation. What does this all mean? It very likely means that the Fed will need to see tighter financial conditions (i.e. wider credit spreads) before taking a significant dovish turn. In other words, the near-term path of least resistance for credit spreads is probably wider, while Treasury yields may remain close to current levels. Bottom Line: Credit spreads are widening due to the combination of weakening global growth and perceptions of restrictive Fed policy. Investors should monitor the indicators of global growth and Fed policy outlined in this report to call the peak in spreads. Housing Update In prior research we stressed the importance of housing as the most important channel through which monetary policy impacts the real economy.4 This makes the U.S. housing market critical for the portfolio duration call. If the housing market has peaked for the cycle, then it likely means that monetary policy has become overly restrictive and that interest rates have also peaked. Chart 6 shows the three most important indicators of the housing market in this regard. Residential investment as a share of potential GDP, the 12-month moving average in single family housing starts and the 12-month moving average in new home sales. At the moment, only residential investment has flattened off, while the other two indicators have maintained their uptrends. While there’s no denying that the housing data have softened in recent months, the bigger picture suggests it is too soon to sound the alarm. Chart 6Housing: The Three Most Important Indicators Housing: The Three Most Important Indicators Housing: The Three Most Important Indicators Rising rates have taken most of the blame for weaker housing data, best exemplified by these comments from the National Association of Realtors’ Chief Economist Lawrence Yun that accompanied last week’s release of October’s existing home sales data: Rising interest rates and increasing home prices continue to suppress the rate of first-time homebuyers. Home sales could further decline before stabilizing. The Federal Reserve should, therefore, re-evaluate its monetary policy of tightening credit, especially in light of softening inflationary pressures to help ease the financial burden on potential first-time buyers and assure a slump in the market causes no lasting damage to the economy.5 There are certainly structural impediments to first-time homeownership, most notably the lack of supply at the low-end of the market. The most recent annual report from the Joint Center For Housing Studies noted that of 88 metropolitan areas with available data, “virtually all” had more homes for sale in the top third of the market by price than in the bottom third.6 However, we do not see the level of interest rates as the major problem for first-time homebuyers or indeed the overall market. In fact, it is very difficult to see how the level of interest rates could be a large drag on the housing market when the household mortgage debt service ratio is as low as it has been since 1980 (Chart 6, bottom panel). So what exactly is going on with housing? It is likely that the recent slow-down in housing activity is not function of the level of mortgage rates, but of the recent sharp increase in mortgage rates. Chart 7 shows that there have been three periods since the financial crisis when mortgage rates jumped sharply: 2013, late-2016 and 2018. All three episodes were followed by a contraction in residential investment about six months later. The recent contraction fits this pattern nicely, which suggests that it should reverse if mortgage rates simply flatten-off for a time. Chart 7The Culprit: Large Rate Spikes The Culprit: Large Rate Spikes The Culprit: Large Rate Spikes Bottom Line: The housing market indicators with the best track records at signaling restrictive monetary policy remain benign, suggesting it is too soon to fret about the end of the Fed’s rate hike cycle. We suspect that recent housing weakness is a function of the large jump in mortgage rates, and that housing activity will recover once mortgage rates moderate their uptrend. Agency MBS On Upgrade Watch Agency MBS have underperformed duration-matched Treasuries so far this year. While they have outperformed corporate credit, they have also lagged other Aaa-rated securitizations (Chart 8). As the cycle progresses, we think Agency MBS spreads will remain relatively tight even after the credit cycle turns and corporate bond defaults rise. We maintain a neutral allocation to MBS for now, but will likely upgrade the sector when it comes time to downgrade corporate bonds from neutral to underweight. Chart 8Agency MBS: Outperforming Corporate Credit But Lagging Other Aaa-Rated Securitizations Agency MBS: Outperforming Corporate Credit But Lagging Other Aaa-Rated Securitizations Agency MBS: Outperforming Corporate Credit But Lagging Other Aaa-Rated Securitizations We like to model excess MBS returns using the following formula: Monthly Excess Returns = a * (1-month lag in OAS) - b * (change in OAS) + c * (change in yields) - d * (squared change in yields) In the above formula, the change in yields proxies for mortgage refinancing risk. Refinancings tend to increase when yields fall and decline when they rise. The squared change in yields proxies for extension risk, and the lagged OAS approximates the carry in the security. The final risk factor is the change in MBS OAS itself.7 Chart 9 shows a performance attribution of monthly MBS excess returns to each of the risk factors listed above. The model coefficients are estimated using only 2018 data, and the November figures are month-to-date. The message from Chart 9 is that while the squared change in yields was a drag on returns early in the year, widening OAS has been the reason for negative excess returns during the past two months. Refinancing risk has been muted all year, and this will likely continue as the Fed tightens policy. Chart 9Agency MBS Performance Attribution A Checklist For Peak Credit Spreads A Checklist For Peak Credit Spreads While a wider OAS has dragged down MBS returns during the past two months, we do not see this becoming a long-term issue for the sector. The OAS tends to widen when banks are tightening lending standards on residential mortgage loans, and at present, lending standards are already quite restrictive compared to history. The median FICO score for new mortgages is a lofty 758 (Chart 10). This suggests that the most likely way forward is continued gradual easing in bank mortgage lending standards (Chart 10, bottom panel). Chart 10Lending Standards Will Continue To Ease Lending Standards Will Continue To Ease Lending Standards Will Continue To Ease Bottom Line: Negative excess MBS returns during the past two months are the result of wider option-adjusted spreads, but continued easing in bank lending standards should prevent OAS from widening dramatically. Maintain a neutral allocation to MBS for now, but look to upgrade at the expense of corporate bonds as the credit cycle progresses.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 5 https://www.nar.realtor/newsroom/existing-home-sales-increase-for-the-first-time-in-six-months 6 http://www.jchs.harvard.edu/state-nations-housing-2018 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “On The MOVE”, dated February 13, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation