High-Yield

Highlights Investors’ perception of “fallen angels” – bonds downgraded from investment grade to high yield – is mostly negative, especially since many believe we are near the end of the economic and credit cycle. In this report, we show that fallen angels can provide investors with an opportunity to invest in relatively high-quality bonds at attractive valuations – bonds which on average outperform other corporate bonds. We find that a good entry-point into fallen angels is usually a week after the bonds are downgraded, after which selling pressures begin to fade. However, investors need to be aware that fallen angels are accompanied by some, less obvious, risks, particularly longer duration and sector skewness. Introduction Chart 1Baa-Rated Bonds Are Now 50% Of The IG Universe Baa-Rated Bonds Are Now 50% Of The IG Universe Baa-Rated Bonds Are Now 50% Of The IG Universe Elevated levels of US corporate debt, as well as declining credit quality in the investment-grade space, have raised investor worries that a large portion of bonds will be downgraded in the next recession and default cycle. The lowest tranche of investment-grade debt, Baa-rated, now constitutes over 50% of the investment-grade index (Chart 1). However, investors tend to dismiss the opportunities that this tranche of debt can provide when downgraded from investment grade to high yield – known as “fallen angels”. The change in the ownership structure of corporate bonds has contributed to the performance of fallen angels. Increasing demand for corporate-bond funds – both mutual funds and ETFs – has displaced direct ownership of corporate bonds by households and financial institutions over the past few years (Chart 2, panels 1 & 2). Chart 2Corporate Bond Ownership Corporate Bond Ownership Corporate Bond Ownership Active fund managers, constrained by their rules to hold only bonds with a certain (usually non-speculative grade) rating, are often forced to sell their holdings ahead of a potential downgrade. In addition, passive funds exacerbate the selling pressure, since they are forced to sell a bond in the event of a downgrade. Insurance companies and pensions funds, the biggest holders of corporate bonds, have increased their allocation to corporate bonds in the search for income in an environment of low yields. Estimates suggest that life insurance companies’ holdings of Baa-rated bonds comprise 34% of their total portfolios.1 However, high-yield bonds represented less than 5% as of the end of 2016.2 There is no regulation prohibiting them from owning sub-investment-grade bonds, but they face higher capital costs when they do. This could also fuel fire sales during the next downgrade cycle. Fallen angels therefore often enter the high-yield index at a much cheaper valuation than bonds that were originally issued as high yield. In fact, during the past two downgrade cycles, in 2007-2008 and 2015-2016, the average spread of fallen angels over an adjusted high-yield index (weighted so that it has the same credit rating as fallen angels) widened by 560 and 130 basis points, respectively (Chart 3). While this seems negative at a first glance, it also leaves more room for spread compression, once market conditions improve, for investors who correctly time their entry into this market. As the bottom panel of Chart 3 shows, investors almost always receive a higher yield for holding fallen angels compared to a similarly rated high-yield basket. Chart 3Fallen Angels Have Mostly Traded At A Discount... Fallen Angels Have Mostly Traded At A Discount... Fallen Angels Have Mostly Traded At A Discount... Chart 4...Despite Their Better Performance ...Despite Their Better Performance ...Despite Their Better Performance In this Special Report, we explain what fallen angels are, analyze their historical risk-return characteristics, and compare them to other major asset classes, particularly high-yield corporate bonds in general. We show that, once downgraded, fallen angels – due to oversold pressures – tend to outperform other asset classes as well as similarly-credit-rated high-yield bonds (Chart 4). We also assess their performance during periods of financial-market stress. Finally, we discuss the risks associated with owning fallen angels, and highlight the vehicles investors can use to access this asset class. What Are Fallen Angels? Fallen angels refer to bonds that have been downgraded from investment grade to junk (or speculative grade). Whereas different commercial indices can have slightly different classifications for the term (discussed below in the Historical Risk And Return section), the generic definition includes bonds previously classified as investment grade but later downgraded to high yield. These transitions can occur from and to any credit rating within both universes. However, the majority of downgrades occur between the lowest tranche of investment-grade bonds, rated Baa, and the highest tranche of high-yield bonds rated Ba (Chart 5). Generally, fallen angels have provided inves­tors with an opportunity to buy higher qual­ity, cheaper, and better performing corpo­rate bonds than those originally issued as high yield. Generally, fallen angels have provided investors with an opportunity to buy higher quality, cheaper, and better performing corporate bonds than those originally issued as high yield. So how do fallen angels differ? Higher quality: Over 73% of bonds within the fallen angels ETF fall into the Ba bucket – the highest tranche in the speculative space — versus 45% within the broader high-yield ETF (Chart 6). Chart 5The Downgrade Transition Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 6Fallen Angels Have Better Credit Quality Than High Yield Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Cheaper: In anticipation of a downgrade, selling pressure from fund managers intensifies, causing prices of “potential” fallen angels to drop prior to their downgrade date. However, our US Bond Strategists report academic findings that show forced fire sales of fallen angels are usually short-lived.3 They conclude that, once Baa-rated securities are downgraded, there is no mechanism to force downward pressure on the price to continue. Chart 7Selling Pressures Intensify Even After The Bonds Are Downgraded Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Academic research corroborates this view: fallen angels exhibit ‘V-shaped’ price action,4 where their prices start falling ahead of a potential downgrade. This is the result of the reaction of active fund managers as discussed earlier. This trend persists for a short while even after the bonds are downgraded, as passive funds – index mutual funds and ETFs – offload the bonds. Selling pressures come to a halt shortly after the downgrade date (on average around seven trading days). This represents an entry-point for investors to add fallen angels to their portfolios. These conclusions are also supported by the price trajectory of a sample5 of fallen angels we tested (Chart 7). Note, however, that the trajectory shown in our results suggests that the attractiveness of fallen angels disappears quite quickly, since prices plateau about three to four months after the downgrade. Chart 8Fallen Angels Peform Better Than Similar High- Yield Bonds Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Better performance: The fallen angels index has outperformed a similarly credit-rated duration-matched high-yield basket in eight out of the 15 years since the index’s inception. In particular, fallen angels have tended to outperform in years when the Federal Reserve was on hold or cutting interest rates, due to their longer average duration of 5.5 years versus 2.9 years for high-yield bonds – as discussed below in the Risks section (Chart 8). Generally, fallen angels are concentrated in sectors that were subject to a recent shock. This was the case in the Telecommunications sector in 2001, the Financials sector in 2007-2008, and the Energy sector in 2014-2015. How Many Fallen Angels Will There Be In The Next Downturn? Over the past three decades, US Baa-rated debt – the lowest tranche in investment grade – has doubled from only 20% of total corporate debt to 40%. This coincided with an increase in nonfinancial corporate debt from 55% of GDP in the mid-1990s to nearly 75% by the end of 2018. Low interest rates over the past 10 years incentivized firms to take advantage of cheaper financing for capital expenditure, equity buybacks, M&A, and more (Chart 9). To a degree, this corporate behavior was rational since businesses understood that their optimal capital structure in a world of low interest rates required them to take on more debt. Simply put, firms found that targeting a Baa rating was more desirable. While rising leverage and weaker corporate health are concerns, we do not see these as imminent risks until the next recession and downgrade cycle hit – which we do not see happening in the next 12 months. For now, there is no worrying trend in downgrades. In fact, there are more “rising stars” – corporate bonds previously classified as high yield that have been upgraded to investment grade – than fallen angels (Chart 10). Nevertheless, it is important for investors to gauge the extent of potential downgrades during the next recession. Chart 9Debt Issuance: A Smart Corporate Decision Debt Issuance: A Smart Corporate Decision Debt Issuance: A Smart Corporate Decision Chart 10Rising Stars Versus Fallen Angels Rising Stars Versus Fallen Angels Rising Stars Versus Fallen Angels Several research papers use historical probabilities and downgrade rates to estimate a range for potential fallen angels. Given that investment-grade bonds currently amount to $5.3 trillion, and that the average peak in the one-year rate of investment-grade bond downgrades over the past four decades was 7.1%, that would imply the amount of new fallen angels in the next recession to be $376 billion. That is three times bigger than the current value of fallen angels, and represents nearly 30% of the entire junk-bond universe.6  Historical Risk And Return Chart 11Fallen Angels Provide Alpha Fallen Angels Provide Alpha Fallen Angels Provide Alpha To assess the performance of fallen angels versus other high-yield bonds, we adjust the indices to which we compare the fallen angels index in two ways. First, we remove the fallen angels from the overall high-yield index. However, that on its own would fail to consider the different credit qualities of the two indices – shown in Chart 6. It would also make it difficult to account for differences in duration. We therefore create a high-yield duration-matched basket with similar credit ratings to the fallen angels index in order to account for this. Fallen angels significantly outperformed both indices (Chart 11). In doing so, we were also able to distinguish between the extra performance due to duration– the gap between the jade and indigo lines – and the alpha created by fallen angels – the gap between the dark green and the jade lines. For the purpose of this report, we use the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Bond Index, which is designed to track USD-denominated fallen angels. The index, based on the market value of the underlying bonds, includes securities that have a current high-yield rating, while having been assigned an investment-grade index rating at some point since issuance. The index relies on the average of three credit-rating agencies, Fitch, Moody’s, and S&P, to qualify bonds for inclusion. It is worth noting that there are other indices that track fallen angels, with different methodologies. For example, the FTSE Time-Weighted US Fallen Angel Index implements a time-weighted metric, assigning a larger weight to recently downgraded securities. It also adds a maximum inclusion period of 60 months. Since the index’s inception, fallen angels have outperformed other fixed-income assets on both an absolute and risk-adjusted return basis (Table 1). In absolute terms, fallen angels had the highest return of all the assets we compared them with. However, that came with an annualized volatility of 1.5 percentage points higher than the similarly rated high-yield basket – albeit not when compared to its duration-matched counterpart. Another explanation is that the extra volatility is a function of the swift fall and recovery in prices, as well as on going turbulence in the impacted sectors. Table 1Historical Risk-Return Characteristics Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Financial Market Stress Having established that fallen angels on average outperform other types of bonds, we now address the question: how do they perform during recessions and other periods of financial market stress? Given the index’s relatively short history, the only recession we are able to cover is the Global Financial Crisis (GFC) of 2007-2009. Nevertheless, we also look at other market crises dating back to 2005. During the GFC, fallen angels fell, similarly to their high-yield peers. However, coming out of the recession, fallen angels’ performance diverged from similarly rated high-yield bonds as well as from Treasurys and investment-grade bonds. Fallen angels have outperformed other similarly rated high-yield bonds after every market stress period over the past 14 years, except the Q4 2018 equity selloff caused by trade tensions (Chart 12). Fallen angels – even when credit and dura­tion are accounted for – have outperformed following periods of broad credit distress. They also seem to outperform during peri­ods of sector-specific distress. Fallen angels – even when credit and duration are accounted for – have outperformed following periods of broad credit distress. They also seem to outperform following periods of sector-specific distress. Chart 12Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Chart 13The Energy Sector: A Perfect Example The Energy Sector: A Perfect Example The Energy Sector: A Perfect Example This was evident in 2015-2017, when Brent crude oil fell from $120 to nearly $40, causing spreads of energy-rated junk bonds to widen dramatically. There was also a rise in corporate downgrades, particularly within the Energy sector. However, as the oil market stabilized and the Energy sector recovered, Energy corporate spreads quickly tightened and fallen angels outperformed a similarly credit-rated high-yield index. In the second half of 2016, the Energy sector comprised 28% of the fallen angels ETF, compared to 13% and 10% of the high-yield and investment grade ETFs respectively (Chart 13).7 Risks The arguments above should make fallen angels of interest to any investor. However, there are also risks, in particular the following: Sector skew: We have shown that fallen angels can be concentrated in sectors going through distress – the oil market in 2014-2015 being a perfect example. It is important to be aware of the sector skew of fallen angels compared to the high-yield and investment-grade bond universes. As of October 2019, the fallen angels universe was skewed towards the Energy, Technology, and the Industrials sectors compared to both high-yield and investment-grade bonds. It was notably underweight Consumer Non-cyclicals (Chart 14). Fallen angels also have a skew towards Banks – 12% as opposed to 2% in the high-yield universe. This might represent an opportunity rather than a risk. It could allow investors to exploit sectoral differences in the credit market. Longer Duration: Fallen angels also present greater duration risk. Given that they were once investment grade, they have a longer maturity of 9.8 years on average, versus 7.1 years for the credit-weighted high-yield basket. That would partially explain why fallen angels’ duration did not decline as much this year when long-term bond yields fell over 100 bps. We expect higher long-term interest rates over the next 12 months, which might hurt the performance of fallen angels (Chart 15). Chart 14Sector Skew: Risk And Opportunity Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 15Fallen Angels: Characteristics Fallen Angels: Characteristics Fallen Angels: Characteristics Idiosyncratic Risks: The most obvious risk would be that the firm is incapable of fixing its balance sheet, and ultimately becomes subject to further downgrades. Catching Fallen Angels Investors now have access to vehicles that track fallen angels, though these ETFs are still new and rather small. ANGL and FALN were launched in 2012 and 2016 and track the BofA Merrill Lynch and Bloomberg Barclays fallen angles indices respectively (Table 2). Table 2ETFs Tracking Fallen Angels Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 16Catching Fallen Angels Catching Fallen Angels Catching Fallen Angels Chart 16 shows the tracking error and tracking difference between the fallen angels index and the FALN ETF. The tracking error for FALN has been higher than the ETF tracking the overall high-yield index (HYG), but the tracking difference has been less volatile. Conclusion        Fallen angels allow investors to buy certain high-yield bonds at an attractive valuation for a period of time. Fallen angels have historically provided a pick-up in risk-adjusted performance over overall high-yield bonds, even when adjusting for quality differences. They have also outperformed investment-grade bonds on a risk-adjusted basis, as well as other asset classes. Investors need to time their entry-point into fallen angels. The ideal timing is usually about a week after the bond is downgraded. The sector weighting of the fallen-angels index tends to be related to a recent market or sector shock. Sector skew and long duration remain the principal risks that investors should be wary of.   Amr Hanafy Research Associate AmrH@bcaresearch.com   Footnotes 1    Please see Financial Times "Search for yield draws US life insurers to risky places", available at https://www.ft.com/ 2   Please see National Association Of Insurance Commissioners, Capital Markets Special Report Index, “U.S. Insurers’ High-Yield Bond Exposure On The Rise”, December 21st 2017. 3   Please see US Bond Strategy Special Report titled “The Risk From US Corporate Debt Part 2: Fund Flows, BBBs, And Leveraged Loans", available at usbs.bcaresearch.com 4   Please see Prof. Andrew Clare, Prof. Stephen Thomas, Dr Nick Motson “Fallen Angels: The investment opportunity”, dated September 2016, Cass Business School. 5   We looked at the 12-month price trajectory (six months before and after the downgrade date) of 60 corporate bonds in the FALN ETF. 6   Please see Moody’s Investors Service, Fallen angels: High-yield market buffers potential transitions amid wider risks, May 13, 2019. 7   We used the iShares Fallen Angels USD Bond ETF (FALN) as a proxy for fallen angels, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) as a proxy for high-yield bonds, and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) as a proxy for investment-grade bonds.

Highlights Prevailing winds are still blowing in favor of the US dollar. Continue shorting a basket of EM currencies versus the greenback. Deflationary forces are gaining momentum in EM/China while inflationary pressures are accumulating in the US economy. The dollar will appreciate further, distributing inflationary pressures away from the US and into EM/China. Feature Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Last week the EM index closed a hair short of this level. Our strategy remains intact: We continue to recommend caution and defensive positioning for EM investors, but will recommend playing the rally if the index breaks above this level. The fact that industrial metals and oil prices have failed to rally substantially even though the S&P 500 is making new highs gives us comfort that the Chinese industrial cycle is not experiencing a revival. Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered.  Absent a sustained recovery in the Chinese capital spending and rising commodities prices, EM equities and currencies will not be able to maintain their rebound. Chart I-1 illustrates that the total return on EM ex-China currencies (including the carry) correlates strongly with industrial metals prices. Similarly, EM share prices move in tandem with global materials stocks (Chart I-2). Chart I-1EM Currencies Correlate Strongly With Industrial Metals Prices bca.ems_wr_2019_11_14_s1_c1 bca.ems_wr_2019_11_14_s1_c1 Chart I-2EM Share Prices Move In Tandem With Global Materials Stocks EM Share Prices Move In Tandem With Global Materials Stocks EM Share Prices Move In Tandem With Global Materials Stocks   The basis for these relationships is as follows: The majority of EM economies, and hence their share prices and exchange rates, are leveraged to China’s business cycle. The latter also drives industrial commodities prices, as the mainland accounts for 50% of global metals consumption. We elaborated on these relationships in our recent report titled EM: Perceptions Versus Reality. In this report, we examine the dichotomy between inflation in EM and US and discuss the macro rebalancing required and the implications for financial markets. Inflation: A Dichotomy Between EM… Low and rapidly falling inflation accompanying extremely weak real growth constitute the current hazards to EM economies and their financial markets: Headline and core inflation in EM ex-China, Korea and Taiwan1 – the universe pertinent for EM bond portfolios – are low and falling, justifying lower interest rates (Chart I-3). Consistently, aggregate nominal GDP growth in these economies is hovering close to its 2015 low (Chart I-4). Chart I-3EM: Inflation Is Low And Falling EM: Inflation Is Low And Falling EM: Inflation Is Low And Falling Chart I-4EM: Nominal GDP Is Subdued And Decelerating EM: Nominal GDP Is Subdued And Decelerating EM: Nominal GDP Is Subdued And Decelerating Chart I-5EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing In China, core consumer price inflation is at 1.5% and falling, and producer prices are declining. Even though many EM central banks have been cutting rates, narrow and broad money as well as bank loan growth are either weak or decelerating (Chart I-5). In brief, policy easing in these economies hasn’t yet revived money and credit growth. The reason why low nominal interest rates have not yet led to a recovery in money/credit is because real (inflation-adjusted) borrowing costs remain elevated. In addition, poor banking system health stemming from lingering non-performing loans – a legacy of the credit boom early this decade – has also hindered credit origination. Corroborating the fact that borrowing costs are high in real (inflation-adjusted) terms, interest rate and credit-sensitive sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. In particular, high-frequency data such as capital goods imports and car sales are shrinking (Chart I-6). Residential property markets are very sluggish in the majority of developing economies (Chart I-7). Chart I-6EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking Chart I-7Property Prices In Local Currency Terms Property Prices In Local Currency Terms Property Prices In Local Currency Terms Chart I-8Chinese Imports For Domestic Consumption And EM Exports Chinese Imports For Domestic Consumption And EM Exports Chinese Imports For Domestic Consumption And EM Exports Finally, the combined exports of EM ex-China, Korea and Taiwan – which are correlated with mainland imports for domestic consumption – are shrinking (Chart I-8). Without a revival in Chinese domestic demand in general, and commodities in particular, EM exports will continue to languish. Bottom Line: Risks stemming from low and falling inflation in EM are rising. While central banks are cutting rates, they are behind the curve. For now, investors should not expect an imminent domestic demand recovery based on EM central bank interest rate cuts. …And The US In contrast to EM, investors and financial markets are complacent about inflation risks in the US. This is not to say that there is a risk of runaway inflation in the US. Our point is as follows: If US growth slows further, US inflation will subside. However, if US growth accelerates, consumer price inflation will surprise to the upside. Sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. US core consumer price inflation has been trending upwards in the past several years, consistent with a positive and widening output gap (Chart I-9, top panel). The average of six core consumer price inflation measures – core CPI, core PCE, trimmed mean CPI, trimmed PCE, market-based core PCE, and median CPI – is slightly above 2% and looks to be headed higher (Chart I-9, bottom panel). US unit labor costs are rising faster than the corporate price deflator (Chart I-10, top panel). A tight labor market will translate to robust wage growth.  Chart I-9Barring Slowdown, US Core Inflation Will Rise Further Barring Slowdown, US Core Inflation Will Rise Further Barring Slowdown, US Core Inflation Will Rise Further Chart I-10Beware Of A US Profit Margin Squeeze Beware Of A US Profit Margin Squeeze Beware Of A US Profit Margin Squeeze   With corporate profit margins already shrinking (Chart I-10, bottom panel) and consumer spending robust, companies will try to pass on higher costs to consumers. Hence, barring a slowdown in US consumer spending, consumer price inflation will likely rise. If global growth recovers, the dollar will sell off and US manufacturing will revive. Provided these two factors have been counteracting inflationary pressures in the US, their reversal will allow inflation to rise. Bottom Line: Underlying core inflation in the US has been drifting higher. Unless growth slows, inflation will surprise to the upside. Macro Rebalancing: In The Dollar’s Favor Bond yields and exchange rates often act as shock absorbers and re-balancing mechanisms for the global economy. The agility and corresponding adjustments of these financial variables assure a more stable real global economy. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. A strong greenback will redistribute inflationary pressures away from the US and into EM. An analogy for this adjustment process is the role of wind in rebalancing air pressure around the globe. When air pressure in location A is higher than in location B, the air moves from location A to location B, causing wind. This allows for a rebalancing of air pressure around the earth. US core consumer price inflation has been trending upwards in the past several years. When air pressure differences are substantial, winds become forceful – potentially to the point of causing damage. In a nutshell, this adjustment could come at the cost of strong winds, or even a storm. Global currency markets play a similar role to wind. A strong greenback will help cap US inflation by dampening activity and employment in America’s manufacturing sector. Slumping manufacturing will moderate activity in the service sector, as well as slowdown aggregate income and spending growth.  In turn, weakening currencies will help reflate EM economies by mitigating the negative impact of lower exports in general and commodities prices in particular. EM economies need an external boost, especially now when their banking systems are in hibernation mode and China is not boosting its demand to the same extent it did during downturns since 2008. A caveat is in order here: In the case of many EMs, currency deprecation will initially hurt growth. The reason is that companies and banks in many EMs still hold large amounts of US dollar debt (Chart I-11). As the dollar appreciates, the cost of foreign debt servicing will escalate, prompting them to reduce corporate spending and bank lending. Hence, wind could turn into a storm. All in all, we continue to bet on EM currency depreciation, regardless of the direction of US bond yields. The basis is as follows: Contrary to widespread consensus, EM exchange rates correlate more strongly with commodities prices – please refer to Chart I-1 on page 1 – than US bond yields as shown in Chart I-12. Chart I-11EM External Debt Is A Risk If EM Currencies Depreciate EM External Debt Is A Risk If EM Currencies Depreciate EM External Debt Is A Risk If EM Currencies Depreciate Chart I-12EM Currencies And US Bond Yields: No Stable Relationship bca.ems_wr_2019_11_14_s1_c12 bca.ems_wr_2019_11_14_s1_c12   Emerging Asian currencies correlate with their export prices and the global trade cycle. Neither global trade activity nor Asian export prices are recovering (Chart I-13). Therefore, the recent bounce in EM currencies is not sustainable.   Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. Could it be that US inflationary pressures are dampened by deflationary tendencies originating from EM/China, producing a benign (goldilocks) scenario for financial markets? It is possible but not likely in the case of EM financial markets. Exchange rates hold the key to all EM asset classes. If the US dollar continues drifting higher – which is our bet – it will stifle the performance of EM equity, local bonds and credit markets (Chart I-14). Chart I-13Asian Export Prices And Container Freight Herald Weaker Regional Currencies Asian Export Prices And Container Freight Herald Weaker Regional Currencies Asian Export Prices And Container Freight Herald Weaker Regional Currencies Chart I-14Trade-Weighted Dollar And EM Share Prices Are Still Correlated Trade-Weighted Dollar And EM Share Prices Are Still Correlated Trade-Weighted Dollar And EM Share Prices Are Still Correlated   Further, Box I-1 on page 10 discusses the 2008 clash between inflationary forces in EM and deflation in the US. Bottom Line: We continue to recommend playing the following EM currencies on the short side versus the dollar: ZAR, CLP, COP, IDR, KRW and PHP. We are also short CNY versus the dollar. For allocations within EM equity, domestic bonds and sovereign credit, please refer to our investment recommendations on pages 16-17. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Box 1 Inflationary + Deflationary Forces = Goldilocks? Will inflationary pressures in the US be offset by disinflation in EM, resulting in a goldilocks outcome globally? A goldilocks period is one in which strong growth is accompanied by moderate inflation. It is possible, but in the global macro world inflation + deflation does not always equal goldilocks. In other words in global macro, (1-1) does not always equal zero. For instance, an inflation dichotomy was present in the first half of 2008. Back then, the US economy was already in recession, with acute deflationary pressures stemming from the deflating housing and credit bubbles. In turn, EM growth was still rampant and inflationary pressures were acute. In fact, in the period between March and mid-July of 2008, US and global bond yields were climbing on the back of rising worries about inflation. In retrospect, such an inflation dichotomy between the US and EM did not result in a goldilocks environment, but occurred on the precipice of the largest deflationary black hole in the post-war period. In the second half of 2008, US deflation overwhelmed EM inflation, generating a major deflationary tsunami worldwide. Russia: Long Domestic Bonds / Short Oil Chart II-1Undershooting CB's 4% Inflation Target Undershooting CB's 4% Inflation Target Undershooting CB's 4% Inflation Target Russia’s growth is already very sluggish. Lower oil prices2 entail both weaker growth and ruble weakness. The primary risk in Russia is low and falling inflation rather than rising inflation. Therefore, unlike in previous downturns, the central bank will be able to engage in counter-cyclical monetary policy, namely continue cutting interest rates. This makes a long position in local currency bonds a “no-brainer”.  The only risk to owning Russian domestic bonds is the ruble depreciation due to falling oil prices and a risk-off phase in EM exchange rate markets. To hedge against these risks, we recommend the following trade: long Russian domestic bonds / short oil. The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. As a result, local bonds on a total- return basis in US dollar terms will outperform oil. The basis to expect a further meaningful drop in interest rates in Russia is as follows: Inflation Is Low And Falling: Various measures of inflation suggest that disinflation is broad based (Chart II-1). As a result, inflation will continue falling towards the central bank’s inflation target of 4%. Crucially, wage growth is decelerating both in nominal and real terms (Chart II-2). Monetary Policy Is Still Restrictive: Even though the central bank has cut rates by 125bps over the past 6 months, monetary policy remains behind the dis-inflation curve. Both policy and lending rates remain too high, especially relative to the low nominal growth environment (Chart II-3). Real borrowing costs stand at 9% for consumer and 4.5% for corporate loans (Chart II-4). The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. Chart II-2Russia: Sluggish Wage Growth Russia: Sluggish Wage Growth Russia: Sluggish Wage Growth Chart II-3Russia: Tight Monetary Policy Russia: Tight Monetary Policy Russia: Tight Monetary Policy   Notably, weakening credit impulses for both business and consumer segments suggest that domestic demand will disappoint (Chart II-5). Chart II-4Russia: High Real Lending Rate Across Sectors Russia: High Real Lending Rate Across Sectors Russia: High Real Lending Rate Across Sectors Chart II-5Weakening Credit Impulses = Lower Demand And Investment Weakening Credit Impulses = Lower Demand And Investment Weakening Credit Impulses = Lower Demand And Investment   Since October 1, the CBR has taken measures to curb consumer borrowing from banking and non-banks credit institutions. These new guidelines limit the latter’s lending to consumers with high debt loads. In short, much lower nominal and real interest rates will be required to reinvigorate domestic demand. Fiscal Policy Is Tight: The government has overplayed its hand in running very tight fiscal policy. The government primary budget surplus now stands at 3.8% of GDP. Government spending growth both in real and nominal terms remains very weak (Chart II-6). The National Project initiative has not yet been sufficient to expand government expenditures. In fact, a recent report from the Audit Chamber suggests that total spending under this National Project program for 2019 will be below government targets of 3% of GDP per year. Finally, the authorities committed a policy mistake at the beginning of year by hiking the VAT tax which has hurt consumption. Russian local currency bond yields are set to fall, even as oil prices decline over the coming months. A Healthy Balance Of Payment (BoP) Position: Total external debt and debt servicing are extremely low by emerging markets standards. Russia has the lowest external debt amongst its EM counterparts. Likewise, Russia’s international investment portfolio liabilities – foreigners’ ownership of equities and bonds – remain one of the lowest amongst EM (Chart II-7). Chart II-6A Lot Of Room To Boost Government Spending A Lot Of Room To Boost Government Spending A Lot Of Room To Boost Government Spending Chart II-7Foreigners' Holding Of Russian Financial Assets Are Low Foreigners' Holding Of Russian Financial Assets Are Low Foreigners' Holding Of Russian Financial Assets Are Low   Investment Recommendations Chart II-8Local Bonds Are Decoupling From Oil Local Bonds Are Decoupling From Oil Local Bonds Are Decoupling From Oil Russian local currency bond yields are set to fall, even as oil prices decline over the coming months (Chart II-8). In light of this, we recommend the following pair trade: long local currency bonds / short oil. Dedicated EM fixed-income portfolios should continue to overweight Russian sovereign and corporate credit, as well as local currency government bonds relative to their respective EM benchmarks. Tight fiscal and monetary policies favor creditors. We have been bullish on Russian markets for some time arguing that they will behave as a low-beta play in EM selloff as discussed in our previous report. This view remains intact. Dedicated EM equity portfolios should continue overweighting Russian stocks, a recommendation made in October 2018. Given the ruble will likely depreciate gradually rather than plunge amid falling oil prices, the authorities will continue cutting rates and provide fiscal stimulus. That will benefit Russia versus many other EM countries. Finally, we remain long the RUB versus the Colombian Peso, a trade instituted on May 31, 2018. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    We exclude economies of China, Korea and Taiwan because they are different in their economic structure and inflation dynamics compared with majority of EMs. 2   BCA’s Emerging Markets Strategy team expects lower oil prices consistent with its thesis of EM slowdown. This is different from BCA’s house view that is bullish on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The mood among investors is shifting from the recessionary gloom of this past summer. Equities worldwide are rallying, buoyed by a combination of dovish monetary policies, tentative signs of bottoming global growth and expectations of some sort of trade détente between the US and China. The latter is fueling more bullish sentiment towards equities in regions most exposed to global trade and manufacturing like Emerging Markets (EM) and Europe. Feature Chart 1Global Corporates: 2016 Revisited? Global Corporates: 2016 Revisited? Global Corporates: 2016 Revisited? Credit investors, in an unusual twist, have been far more optimistic than their equity brethren. Corporate bonds have delivered solid performance in 2019, with the Bloomberg Barclays Global Corporates total return index up +9.5% year-to-date. This is a surprising development, as global growth concerns triggered a major decline in developed market government bond yields but no widening of credit risk premia (Chart 1). With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The overriding message from the latest read of our CHMs is that the manufacturing-led slowing of global growth this year has not resulted in much deterioration in overall corporate creditworthiness. There are fascinating cross-currents within the data, however. On a regional basis, the CHMs in the euro area, the UK and Canada are in better shape than in the US and Japan. The most interesting differences are across credit quality, with our “bottom-up” high-yield (HY) CHMs looking better than the investment grade (IG) equivalents in both the US and euro area, mostly due to greater relative increases in IG leverage. Our current global corporate bond investment recommendations broadly follow the trends signaled by our CHMs: an aggregate overweight stance versus global government debt, but with a “reverse quality bias” favoring HY over IG in the US and Europe. With government bond yields now on the rise across the developed markets – and with credit spreads fairly tight across the majority of countries - the period of hyper-charged absolute corporate bond returns is over. Expect more carry-like excess returns over sovereigns during the next 6-12 months. US Corporate Health Monitors: Steady Deterioration, Mostly Within Investment Grade Our top-down US CHM is sending a negative message on credit quality, staying in the “deteriorating health” zone since 2015 (Chart 2). The structural declines in the profitability ratios (return on capital and operating margin), debt coverage and, more recently, short-term liquidity are the main causes of that deterioration in US corporate health. Not all the news is negative, however. While operating margins have clearly peaked, they remain at a very high level. The top-down interest coverage ratio is also improving, thanks to low corporate borrowing rates. That is a welcome development that will help extend the US credit cycle by keeping downgrade/default risk, and the credit spreads required to compensate for it, subdued. When looking at our bottom-up US CHMs, the story becomes more nuanced. The bottom-up US high-yield CHM is signaling a surprisingly positive story, spending the past two years in “improving health” territory. The bottom-up US IG CHM remains above the zero line, as has been the case since 2012 (Chart 3). The multi-year increase in the debt-to-equity ratio, and declines in return on capital and interest coverage over the same period, are the main reasons why US IG corporate health has worsened, even as profit margins have stayed high. Chart 2Top-Down US CHM: Steadily Worsening Top-Down US CHM: Steadily Worsening Top-Down US CHM: Steadily Worsening Chart 3Bottom-Up US IG CHM: Some Areas Of Concern Bottom-Up US IG CHM: Some Areas Of Concern Bottom-Up US IG CHM: Some Areas Of Concern The bottom-up US HY CHM is signaling a more positive story, spending the past two years in “improving health” territory (Chart 4), led by stable balance sheet leverage and improvements in operating margins and return on capital. The absolute levels of interest and debt coverage ratios for US HY remain low – a potential future risk for US HY when the US economy goes into its next prolonged downturn. One common signal from all our US CHMs, both top-down and bottom-up, is that short-term liquidity ratios have declined. Those moves are driven by increases in the denominator of the ratios (the market value of assets for the top-down CHM, and the value of current liabilities in the bottom-up CHMs), rather than declines in working capital or cash on corporate balance sheets – trends that would typically precede periods of corporate distress. Just last week, we downgraded US IG to neutral, while maintaining an overweight tilt on US HY.1 The rationale for the move was based on value, as spreads for all US IG credit tiers had tightened to our spread targets, which is not yet the case for HY. The message from our bottom-up US CHMs supports that recommendation. The combination of improving global growth and a Fed that will stay dovish until US inflation has sustainably moved higher paints a favorable backdrop for the relative performance of all US corporate debt versus Treasuries. However, given our expectation that US bond yields will continue to move higher over the next 6-12 months, the lower interest rate duration of US HY relative to IG also supports favoring the former over the latter (Chart 5). Chart 4Bottom-Up US HY CHM: Looking Better Than IG (!) Bottom-Up U.S. HY CHM: Looking Better Than IG (!) Bottom-Up U.S. HY CHM: Looking Better Than IG (!) Chart 5US Corporates: Stay Overweight HY & Neutral IG U.S. Corporates: Stay Overweight HY & Neutral IG U.S. Corporates: Stay Overweight HY & Neutral IG Euro Corporate Health Monitors: Some Cyclical Weakness Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area IG, the gap between domestic and foreign issuers has been widening, with the former now in “deteriorating health” territory (Chart 6). Leverage has gone up for all issuers, with debt/equity ratios now above 100%, but the pace of increase has been faster for domestic issuers. Return on capital and profit margins for domestic issuers have declined since the start of 2018 alongside the prolonged slowing of euro area economic growth. For domestic euro area IG issuers, interest coverage has been steadily climbing since 2015 when the ECB went to negative rates and, more importantly, started its Asset Purchase Program that included corporate debt. Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area HY, the signal from the bottom-up CHM is more positive for both domestic and foreign issuers (Chart 7), with both CHMs sitting just in the “improving health” zone. Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers than foreign issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, with both above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. We have maintained a moderate overweight stance on euro area corporates, both for IG and HY, since the summer of this year (Chart 9). This view was based on expectations that the European Central Bank (ECB) would ease monetary policy, not on a forecast that euro area growth would revive organically. That outcome came to fruition when the ECB cut rates in September and restarted asset purchases earlier this month. The ECB’s moves create a more supportive monetary backdrop (along with an undervalued euro) that will help keep euro area credit spreads tight – a trend that is reinforced by decent corporate health. Chart 8Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Chart 9Euro Area Corporates: Stay Overweight IG & HY Euro Area Corporates: Stay Overweight IG & HY Euro Area Corporates: Stay Overweight IG & HY Chart 10Relative Bottom-Up CHMs: Turning In Favor Of The US? Relative Bottom-Up CHMs: Turning In Favor Of The US? Relative Bottom-Up CHMs: Turning In Favor Of The US? We see no reason to alter our recommendations on euro area credit, based on our forecast of better global growth, with no change to the ECB’s ultra-accommodative monetary stance, in 2020. However, a stronger growth backdrop could benefit euro area HY performance more than IG, based on the comparatively healthier signal from the bottom-up euro area HY CHM. The gap between the combined IG/HY bottom-up CHMs for the US and euro area aligns with credit spread differentials between euro area and US issuers (Chart 10).2 latest trends show a narrowing of the gap between the US and euro area CHMs, suggesting relative corporate health favors US names (middle panel). At the same time, the stronger performance of the US economy, which is much less levered to global trade and manufacturing compared to Europe, continues to support US corporate performance versus euro area equivalents (bottom panel). UK Corporate Health Monitor: Some Improvement, Even With Brexit Uncertainty Despite the persistent uncertainty over the UK-EU Brexit negotiations that has weighed on UK economic confidence, our top-down UK CHM remains in the "improving health" zone (Chart 11). All of the individual components are contributing to the strength of the CHM, which even improved from those healthy levels in Q2/2019 (the most recent data available). A sustained easing of UK financial conditions – easy monetary policy alongside a deeply undervalued currency – have helped boost interest/debt coverage ratios by keeping UK corporate borrowing costs low. Top-down operating margins for UK non-financial firms have surprisingly increased and now sit just under 25%. Short-term liquidity remains solid with leverage holding at non-problematic levels. As we discussed in a recent Special Report, the UK economy has been holding up fairly well despite the political uncertainty that has driven a prolonged slowdown in productivity growth through weak business investment.3 The UK consumer has continued to spend, however, seemingly desensitized to the political drama, and the labor market has remained tight enough to support a decent pace of household income growth. Despite the persistent uncertainty over the UK-EU Brexit negotiations, our top-down UK CHM remains in the "improving health" zone. The near term performance of the UK's economy is highly dependent on the final result of Brexit negotiations. If a negotiated Brexit occurs, UK corporates can start to ramp up the capital spending that has been delayed due to the political uncertainty, which will eventually lead to an improvement in UK productivity growth and overall corporate performance. A strengthening pound and rising government bond yields, driven by markets unwinding Brexit risk premia, will mitigate some of that growth thrust, but the net effect will still boost the relative performance of UK corporate debt versus Gilts. There are still near-term political risks stemming from the UK parliamentary election next month, with the deadline for a UK-EU Brexit deal delayed until after the election. Thus, we continue to maintain only a neutral stance on UK IG corporates in our model bond portfolio, despite our overall bias to be overweight global corporate debt versus government bonds. We will reconsider that stance after we have more clarity on the final resolution of the Brexit uncertainty. At a minimum, however, we expect UK corporates to continue to deliver solid excess returns versus UK Gilts (Chart 12). Chart 11UK Top-Down CHM: Solid Improvement, Despite Brexit U.K. Top-Down CHM: Solid Improvement, Despite Brexit U.K. Top-Down CHM: Solid Improvement, Despite Brexit Chart 12UK Corporates: Stay Neutral U.K. Corporates: Stay Neutral U.K. Corporates: Stay Neutral Japan Corporate Health Monitor: A Further Cyclical Deterioration Our bottom-up Japan CHM remains in the "deteriorating health" zone, as has been the case since the start of 2018 (Chart 13).4 The message from the individual CHM components, however, is that this is a cyclical, not structural, deterioration in Japanese corporate credit quality, and from a very healthy starting point. Leverage, defined here as the ratio of total debt to the book value of equity, is slightly above 100%, well below the 100-140% range seen between 2006 and 2015. A similar trend exists for return on capital, which has dipped below 5% but remains high relative to its history (although very low by global standards). Operating margins, debt coverage and short-term liquidity are down from recent peaks but all remain well above the lows of the decade since the 2008 financial crisis. Interest coverage has suffered a more meaningful deterioration relative to its history. However, this is more a cyclical issue related to falling profits (the numerator of the ratio) rather than rising interest costs (the denominator), with the latter remaining subdued thanks to the Bank of Japan’s hyper-easy monetary policy. For the former, the cyclical momentum in Japan’s economy is not improving, despite some recent evidence that global growth may be stabilizing. According to the latest Tankan survey, Japanese manufacturers – who saw profits fall -31% on a year-over-year basis in Q2/2019 - reported a worse business outlook than previously expected, both for large and small firms. This is not surprising, as Japan’s economy remains highly levered to global growth and export demand, in general, and China, in particular. Yet the less trade-sensitive services sector has also weakened – forecasts of the Tankan non-manufacturing index have already rolled over and the services PMI dropped to 49.7 in October. Japan’s corporate spread has widened slightly (+10bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets. This is sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns (on a duration-matched basis) versus Japanese Government Bonds (JGBs); yields on the latter will remain anchored near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM.  Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Japan Bottom-Up CHM: Cyclical Deterioration Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Japan Corporates: Stay Overweight Vs JGBs For Carry Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitors: Continuous Improvement Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving” zone as of the latest data available from Q2/2019 (Chart 15). The cyclical components (return on capital and operating margins) have gradually improved over the past three years, but remain relatively weak compared to history. Leverage is rising (now above 120% in our bottom-up CHM), but interest/debt coverage ratios remain steady and, in the case of the bottom-up CHM, have outright improved over the past year. We reviewed the Canadian economy last week5 and concluded that a Bank of Canada interest rate cut was unlikely because of signs of improving domestic growth momentum at a time when core inflation was at the midpoint of the BoC’s 1-3% target range. Overall, Canadian growth has been resilient in the face of the 2019 global manufacturing downturn, and should re-accelerate in the next year led by a firm consumer with rebounding housing and business investment. This should help boost the cyclical components of our Canada CHMs, especially if some improvement in global growth helps lift demand for Canadian commodity exports. We also introduced a framework to analyze Canadian corporate bonds in a Special Report published in late August.6 We concluded that Canadian companies’ financial health remains a positive for corporate bond returns on a cyclical basis, but high leverage and mediocre profitability were longer-term concerns. We also noted that the higher credit quality of Canadian corporates, where only 40% of the investment grade index is rated BBB, made them more potentially appealing on a creditworthiness basis relative to the lower quality markets in the US (50% BBB share) and euro area (52%). We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have held in a well-established range of 100-200bps since the 2009 recession (Chart 16), even during periods when our CHMs were indicating worsening corporate health. Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Canada CHMs: Still Healthy, Despite Slower Growth Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More Top-down CHMs are now available for the US, euro area, the UK and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.7 The financial data of a broad set of individual US and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcareseach.com. 2 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from US companies that issue in the euro area market that are part of our US CHMs. 3 Please see BCA Research Global Fixed Income Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated September 20, 2019, available at gfis.bcaresearch.com. 4 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Special Report, “The Great White North: A Framework For Analyzing Canadian Corporate Bonds”, dated August 28, 2019, available at gfis.bcaresearch.com. 7 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Appendix 2: US Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR   APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR   The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Chart I-1Lebanese Bond Yields Have Surged To Precarious Levels Lebanese Bond Yields Have Surged To Precarious Levels Lebanese Bond Yields Have Surged To Precarious Levels In a May 2018 Special Report, we warned that a devaluation and government default were only a matter of time in Lebanon. The country's sovereign US dollar bond yields have now reached a whopping 21% and local currency interest rates stand at 18% (Chart I-1). On the black market, the Lebanese pound is already trading 12% below its official rate. A public run on banks and bank deposit moratorium, as well as public debt default and a massive currency devaluation are now unavoidable. A Classic Case Of EM Bank Run And Currency Devaluation… The current state of Lebanon’s balance of  payments (BoP) is disastrous: The current account (CA) deficit has oscillated between 10% and 20% of GDP in the past 10 years (Chart I-2). This wide CA deficit has been funded by speculative portfolio flows into local currency government bonds, sovereign bonds and bank deposits. However, since the middle of 2018 these inflows have dried up. In turn, to defend the currency peg to the US dollar and avoid a currency depreciation in the face of the BoP deficit, the Central Bank of Lebanon (BDL) has been depleting its foreign exchange (fx) reserves, i.e., the central bank has been financing the BoP deficit (Chart I-3). Chart I-2Lebanon's Chronic Current Account Deficit Lebanon's Chronic Current Account Deficit Lebanon's Chronic Current Account Deficit   Chart I-3Lebanon: The BoP Has Been Deteriorating Substantially Lebanon: The BoP Has Been Deteriorating Substantially Lebanon: The BoP Has Been Deteriorating Substantially   BDL’s gross fx reserves – including gold – have dropped from $48 billion in 2018 to its current level of $43 billion. We estimate that BDL’s net foreign exchange reserves excluding commercial banks’ US dollar deposits at BDL are at just $26 billion. This amount is insufficient in light of the panic-induced outflows the country and the banking system are experiencing.1  As a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon. Chart I-4Depositors’ Are Heading For The Exit Depositors' Are Heading For The Exit Depositors' Are Heading For The Exit Worryingly, as a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon.2   Moreover, after opening their doors, Lebanese commercial banks are now imposing unofficial capital controls – they are paying US dollar deposits in local currency only and are no longer providing dollar-denominated credit lines to businesses and importers. This will only intensify the panic among depositors. Chart I-4 illustrates that local currency deposits have already been declining while US dollar deposits have been slowing, and will likely begin contracting soon. In short, capital outflows will intensify in the coming weeks as people and businesses quickly realize that banks cannot meet their demand for deposits. Critically, we suspect Lebanese commercial banks are short on US dollars to meet people’s demand for the hard currency. Commercial banks’ net foreign currency assets stand at negative $70 billion or 127% of GDP. They hold, roughly, somewhere around $20 billion worth of US dollars in the form of liquid and readily available deposits (in banks abroad and deposits in the central bank) versus $124 billion worth of dollar deposits. Over the years, Lebanese commercial banks have been an attractive place for investors and residents to park their US dollars given the high interest rate paid by the banks. In turn, Lebanese commercial banks have been converting these US dollar deposits into local currency in order to buy government bonds. With domestic bonds yielding well above the rates on US dollar deposits - and given the exchange rate peg to the dollar - commercial banks have been de facto playing the carry trade. In addition, commercial banks also lent some of these dollars directly to the private sector. With the economy collapsing and the widening dollar shortage, banks will not be able to either collect their dollar loans or purchase dollars in the market.   Without new dollar funding – which is very likely to persist – banks will fail to meet the demand for dollars. As a result, a bank run is imminent. At this point, the sole option is for the central bank to keep pushing local interest rates higher to discourage capital flight and a run on the banks. Yet, at 18% and surging, interest rates will suffocate the Lebanese economy and the property market. This will dampen sentiment further and cause a bank run. Bottom Line: A bank run is brewing and bank moratorium as well as currency devaluation are inevitable. …As Well As Public Debt Default Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Chart I-5Public Debt Dynamics Are Toxic Public Debt Dynamics Are Toxic Public Debt Dynamics Are Toxic Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Commercial banks own 37% of outstanding government debt. This will come on top of skyrocketing private-sector non-performing loans and will push banks into outright bankruptcy. Lebanon’s fiscal and public debt dynamics have reached untenable levels. The fiscal deficit stands at 10% of GDP and total public debt stands at 150% of GDP (Chart I-5). Surging government borrowing costs will push interest payments as a share of government aggregate expenditures to extremely high levels. These are unsustainable fiscal and debt arithmetics (Chart I-6). Meanwhile, government revenues will decline as growth falters (Chart I-6, bottom panel). The pillars of the Lebanese economy – private credit growth and construction activity – have been already collapsing (Chart I-7). Chart I-6Surging Interest Rates Will Make Public Debt Servicing Impossible Surging Interest Rates Will Make Public Debt Servicing Impossible Surging Interest Rates Will Make Public Debt Servicing Impossible Chart I-7Lebanon: Domestic Economy Has Been Collapsing Lebanon: Domestic Economy Has Been Collapsing Lebanon: Domestic Economy Has Been Collapsing Bottom Line: The Lebanese government will be forced to default on both local currency and dollar debt. This will be the final nail in the coffin of the Lebanese banking system.    Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes 1    BDL does not publish its holding of net foreign exchange reserves. However, other estimates of BDL’s net fx reserves  are even lower. Please refer to the following paper: Financial Crisis In Lebanon, by Toufic Gaspard and the following article: Lebanon Warned on Default and Recession as Its Reserves Decline. 2   Banks shut down allegedly as a result of the ongoing civil disobedience that was sparked by the government’s reckless decision to tax WhatsApp's call service. The protests quickly escalated to a country-wide uprising, causing the government to resign on October 29.

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

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

Analysis on Mexico and Central Europe is available on pages 6 and 10, respectively. Highlights Deflationary pressures have been intensifying in Malaysia and the central bank will be forced to cut its policy rate. To play this theme, we recommend receiving 2-year swap rates. In Mexico, pieces are falling into place for stocks to outperform the EM equity benchmark on a sustainable basis. We are also keeping an overweight allocation on Mexican sovereign credit and local currency bonds. In Central Europe (CE), inflation will continue to rise as both labor shortages and ultra-accommodative monetary and fiscal policies promote strong domestic demand. We are downgrading our allocation of CE local currency bonds from overweight to neutral. Malaysia: Besieged By Deflationary Pressures Malaysian interest rates appear elevated given the state of its economy. Deflationary pressures have been intensifying and the central bank will be forced to cut its policy rate. The Malaysian economy continues to face strong deflationary pressures. To play this theme, we recommend receiving 2-year swap rates. We are also upgrading our recommended allocation to Malaysian local currency and U.S. dollar government bonds for dedicated EM fixed-income portfolios from neutral to overweight. The Malaysian economy continues to face strong deflationary pressures, requiring significant rate cuts by the central bank: Chart I-1 shows that the GDP deflator is flirting with deflation, and nominal GDP growth has slowed to the level of commercial banks’ average lending rates. Falling nominal growth amid elevated corporate and household debt levels is an extremely toxic mix (Chart I-2, top panel). Notably, debt-servicing costs for the private sector – both businesses and households – are high at 13.5% of GDP and are also rising (Chart I-2, bottom panel).  Chart I-1The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation Chart I-2High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households Crucially, real borrowing costs are elevated. In real terms, the prime lending rate stands at 5% when deflated by the GDP deflator, and at 3% when deflated by headline CPI. Notably, private credit growth (outstanding business and household loans) has plunged to a 15-year low (Chart I-3), underscoring that real borrowing costs are excessive. Chart I-3Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Chart I-4Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia’s corporate sector is struggling. The manufacturing PMI is below the critical 50 threshold and is showing no signs of recovery. Listed companies’ profits are shrinking (Chart I-4, top panel). Poor corporate profitability is prompting cutbacks in capex spending (Chart I-4, middle and bottom panels) and weighing on employment and wages. The household sector has been retrenching; retail sales have been contracting and personal vehicle sales have been shrinking (Chart I-5). The property market – in particular the residential sub-sector – is still in recession. Property sales and starts are falling, and property prices are flirting with deflation (Chart I-6).   Critically, monetary policy easing and exchange rate depreciation are the only levers available to policymakers to reflate the economy. Fiscal policy is constrained as the budget deficit is already large at 3.4% of GDP, and public debt is elevated. Prime Minister Mahathir Mohamad is in fact aiming to reduce the total national debt (including off-balance-sheet debt) back to the government’s ceiling of 54% of GDP (from 80% currently). Chart I-5Malaysian Households Are Retrenching Malaysian Households Are Retrenching Malaysian Households Are Retrenching Chart I-6Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn   Bottom Line: The Malaysian economy is besieged by deflationary pressures and requires lower borrowing costs. The central bank will deliver rate cuts in the coming months. Investment Recommendations A new trade idea: receive 2-year swap rates as a bet on rate cuts by the central bank. Consistently, for dedicated EM bond portfolios, we are upgrading local currency and U.S. dollar-denominated government bonds from neutral to overweight. Chart I-7Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds While we are downbeat on the ringgit versus the U.S. dollar, Malaysian domestic bonds will likely outperform the EM GBI index in common currency terms on a total return basis (Chart I-7, top panel). The same is true for excess returns on the country’s sovereign credit (Chart I-7, bottom panel).     The basis for the ringgit’s more moderate depreciation, especially in comparison with other EM currencies, is as follows: First, foreigners have reduced their holdings of local currency bonds. The share of foreign ownership has declined from 36% in 2015 to 22% now of total outstanding local domestic bonds in the past 4 years (Chart I-8). Hence, currency depreciation will not trigger large foreign capital outflows. Second, the trade balance is in surplus and improving. This will provide a cushion for the ringgit. Finally, the ringgit is cheap in real effective terms which also limits the potential downside (Chart I-9).   Dedicated EM equity portfolios should keep a neutral allocation on Malaysian stocks. We are taking profits on our long Malaysian small-cap stocks relative to the EM small-cap index position. This recommendation has generated a 6.6% gain since its initiation on December 14, 2018. Chart I-8Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Chart I-9The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Mexico: Raising Our Conviction On Equity Outperformance Mexican local currency bonds, as well as sovereign and corporate credit, have been one of our highest conviction overweights for some time. These positions have played out very well (Chart II-1). Presently, pieces are falling into place for Mexican stocks to outperform the EM equity benchmark on a sustainable basis. First, long-lasting outperformance by Mexican local currency bonds and corporate credit will lead to the stock market’s outperformance relative to the EM benchmark. Chart II-2 shows that when Mexican local currency bond and corporate dollar bond yields fall relative to their EM peers, the Bolsa tends to outperform. In brief, a relative decline in the cost of capital will eventually translate into relative equity outperformance. Chart II-1Mexico Vs. EM: Domestic Bonds And Credit Markets Mexico Vs. EM: Domestic Bonds And Credit Markets Mexico Vs. EM: Domestic Bonds And Credit Markets Chart II-2Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Second – as discussed in detail in our previous Special Report – market worries about Mexico’s fiscal position are overblown, especially relative to other developing nations such as Brazil and South Africa. Orthodox fiscal and monetary policies, as well as low public debt, warrant a lower risk premium in Mexico, both in absolute terms and relative to other EM countries. Moreover, market participants and credit agencies have overstated the precariousness of Pemex’s debt and financing requirements. Pemex U.S. dollar bond yields have been falling steadily compared to EM aggregate corporate bond yields since the announcements of policies aimed at supporting the company’s debt sustainability. We have discussed Pemex’s financial sustainability and its effect on public finances in past reports.1  Third, having cut rates twice since September, the Central Bank of Mexico (Banxico) has embarked on a rate cutting cycle. This is positive for stock prices, as it implies higher equity valuations and will eventually put a floor under the economy.  Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. Banxico members have been vocal about their desire to cut rates further, which is being foreshadowed by the swap market (Chart II-3, top panel). Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. The slowdown in the domestic economy and Andrés Manuel López Obrador’ (AMLO) administration’s tight fiscal policy will enable and encourage Banxico to further ease monetary policy (Chart II-3, bottom panel). Fourth, another positive market catalyst for Mexican equities is the ongoing outperformance of EM consumer staples versus the overall EM index. Consumer staples have a large 35% share of the overall Mexico MSCI stock index, while this sector in the EM MSCI benchmark accounts for only 7%. Therefore, durable outperformance by consumer staples often hints at a relative cyclical outperformance for the Mexican bourse (Chart II-4). Chart II-3Mexico: Continue Betting On Lower Rates Mexico: Continue Betting On Lower Rates Mexico: Continue Betting On Lower Rates Chart II-4Mexican Equities Are A Play On Consumer Staples Mexican Equities Are A Play On Consumer Staples Mexican Equities Are A Play On Consumer Staples Chart II-5Mexican Stocks Offer Reasonable Value Mexican Stocks Offer Reasonable Value Mexican Stocks Offer Reasonable Value Finally, Mexican equities are not expensive. Chart II-5 illustrates that according to our cyclically-adjusted P/E ratios, Mexican stocks offer good value in both absolute terms and relative to EM overall. We continue to believe AMLO’s administration is proving to be a pragmatic government with the aim of reducing rent-seeking activities and addressing structural issues such as poverty, corruption and crime. These policies will be positive for the economy over the long run and share prices will move higher in anticipation. Bottom Line: We are reiterating our overweight allocation on Mexican sovereign credit and domestic local currency bonds within their respective EM benchmarks. With further rate cuts on the horizon, yet upside risks to EM local currency bond yields, we continue to recommend a curve steepening trade in Mexico: receiving 2-year and paying 10-year swap rates.  We now have high conviction that Mexican share prices will stage a cyclical outperformance relative to their EM peers. The bottom panel of Chart II-4 on page 8 illustrates that Mexican stocks seem to have formed a major bottom and are about to begin outperforming the EM equity benchmark. Dedicated EM equity managers should have a large overweight allocation to Mexican stocks. Our recommendation of favoring small-caps over large-cap companies in Mexico has been very profitable since we argued for this trade last November. We are taking a 12.9% profit on this position and recommend keeping an overweight allocation to both Mexican large- and small-caps within an EM equity portfolio.   Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Central Europe: An Inflationary Enclave In Deflationary Europe Our macroeconomic theme for Central European (CE) economies – Hungary, Poland and the Czech Republic, elaborated in the linked report, has been as follows: Inflation will continue to rise as both labor shortages and ultra-accommodative monetary as well as fiscal policies in CE promote strong domestic demand. CE economies have stood out as an inflationary enclave in Europe. Notably, CE economies have stood out as an inflationary enclave in Europe. Going forward, inflation will continue to rise across this region, despite the ongoing contraction in European manufacturing. First, Hungary’s and Poland’s central banks are behind the curve – they remain reluctant to hike rates amid rampantly rising inflation within overheating economies (Chart III-1). In turn, real policy rates across CE are becoming more negative and will promote robust money and credit growth (Chart III-2).      Chart III-1CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve Chart III-2Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Policymakers are justifying stimulative policies by stressing ongoing woes in the Europe-wide manufacturing downturn. Yet, they are paying little attention to genuine inflationary pressures in their own economies. Most notably in Hungary, the National Bank of Hungary (NBH) has been aggressively suppressing its policy rate and engaging in a corporate QE program, despite rising inflation and an overheating economy. Similarly, the National Bank of Poland (NBP) seems inclined to cut rates sooner rather than later. On the other end of the spectrum though, the Czech National Bank (CNB) is the only CE central bank to have embarked on a rate hiking cycle over the past 18 months. Going forward, the CNB looks most likely to normalize rates by continuing its hiking cycle. This development will favor rate differentials between it and the rest of CE. As such, we remain long the CZK versus both the HUF and PLN (Chart III-3). Chart III-3Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Chart III-4Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Second, European manufacturing cycles have historically defined CE inflation trends, with time lags of around 12 to 18 months. However, this time around, the euro area manufacturing recession will not translate into slower CE inflation and growth dynamics (Chart III-4). Above all, booming credit induced by real negative borrowing costs has incentivized robust domestic demand in general and construction activity in particular in CE. In addition, employment growth remains strong and double-digit wage growth has supported strong consumer spending (Chart III-5). As a result, manufacturing production volumes have remained relatively resilient in Hungary and Poland, even as manufacturing output volumes in both Germany and the broader euro area have been contracting (Chart III-6). Chart III-5Strong Domestic Demand In CE… bca.ems_wr_2019_10_31_s3_c5 bca.ems_wr_2019_10_31_s3_c5 Chart III-6...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area Third, inflationary pressures in CE are both acute and genuine. Wage growth has been rising faster than productivity growth across the region, leading to surging unit labor costs (Chart III-7). Mounting wage pressures reflect widespread labor shortages. Further, output gaps in these economies have turned positive, which has historically been a precursor of inflationary pressures. Finally, fiscal policy in CE will remain very expansionary, supporting strong business and consumer demand. Bottom Line: Super-accommodative monetary and fiscal policies have led to a classic case of overheating within CE, particularly in Hungary and Poland, and less so in the Czech Republic. Chart III-7Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Chart III-8A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating Investment Implications Deteriorating current accounts (Chart III-8), rising inflation and behind-the-curve central banks warrant further currency depreciation in both Hungary and Poland. This is why we continue to recommend a short position on both the HUF and PLN versus the CZK. We are closing our Hungarian/euro area relative three-year swap rate trade with a loss of 87 basis points. Our expectation that the market would price in rate hikes in Hungary despite the central bank’s dovishness has not materialized. Investors should remain overweight CE equities within an EM portfolio due to strong domestic demand in these economies and no direct economic exposure to China. As we expect EM equities to underperform DM stocks, we continue to recommend underweighting CE versus the core European markets. We are downgrading our allocation to CE local currency bonds from overweight to neutral within an EM domestic bond portfolio. The primary reason is a risk of a selloff in core European rates.   Anddrija Vesic Research Analyst andrija@bcaresearch.com     Footnotes 1. Please see Emerging Markets Strategy, "Mexico: The Best Value In EM Fixed Income," dated April 23, 2019 and "Mexico: Crying Out For Policy Easing," dated September 5, 2019, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Analysis on Chile is available below. EM local bond yields have decoupled from their traditional macro drivers. This could be a sign that EM domestic bonds are entering a New Normal. We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as their currencies depreciate. Only time will tell whether the recent decoupling between EM local bond yields and their currencies is due to investor complacency or represents a sustainable paradigm shift. We are instituting a buy stop on the MSCI EM equity index at 1075. If and when the EM stock index in dollar terms breaks decisively above this level, we will become cyclically bullish and recommend playing the rally. Feature EM local currency bond yields have fallen below their 2013 lows (Chart I-1) – levels not reached since before the Federal Reserve-induced “Taper Tantrum” in the spring of 2013, when EM domestic bond yields spiked and currencies plunged. Crucially, in a major departure from their historical relationship, the aggregate EM GBI index of local bond yields has decoupled from EM currencies (Chart I-1), commodities prices, EM U.S dollar-denominated sovereign bond yields and the global business cycle (Chart I-2). Chart I-1EM Local Bond Yields Have Decoupled From EM Currencies EM Local Bond Yields Have Decoupled From EM Currencies EM Local Bond Yields Have Decoupled From EM Currencies Chart I-2EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers   Will this decoupling persist, or will the past relationship be re-established? In other words, have EM local currency bonds entered a New Normal – a paradigm where their yields behave like DM yields – falling during deflationary periods and rising during business cycle recoveries? What We Got Right And Wrong We had not been anticipating such a large drop in EM domestic bond yields this year. Our analysis has been based on the following pillars: That the global trade and manufacturing recession would persist until late 2019, and that such an outcome would herald lower commodities prices and weaker EM currencies. Falling resource prices and EM currency deprecation, consistent with the history shown in Chart I-1 and I-2, would lead to a foreign investor exodus from EM local bonds, reinforcing currency depreciation and somewhat higher yields.   Our theme that the global trade and manufacturing recession has been driven by weak domestic demand in China and the rest of the EM has played out quite well; commodities prices have been weak and EM currencies have depreciated. In addition, the broad trade-weighted dollar has been strong and DM bond yields have plunged in the past 12 months, in line with our theme of a global growth slump. In a major departure from their historical relationship, the aggregate EM GBI index of local bond yields has decoupled from EM currencies commodities prices, EM U.S dollar-denominated sovereign bond yields and the global business cycle. Nevertheless, our view of a selloff in EM domestic bonds has not panned out. In other words, our spot-on macro analysis has not translated into a successful investment call on the direction of EM local yields. The reason has been a change in the relationship between EM bond yields and their typical global macro drivers, specifically EM currencies. A potential counter-argument could be that falling DM bond yields have pushed EM local yields lower. However, contrary to the widespread consensus view, both EM local bond yields and currencies have illustrated a relatively weak correlation with U.S. bond yields (Chart I-3). All in all, even though our macro view has been on the ball, we have been flat-footed by the shifting relationship between EM domestic bond yields and their traditional macro drivers as illustrated in Chart I-1 and I-2.  Finally, even though EM bond yields have plunged, their total returns in U.S. dollar terms have not been spectacular (Chart I-4, top panel). Crucially, the EM GBI total return index in dollar terms has not outperformed that of duration-matched U.S. Treasurys (Chart I-4, bottom panel). Chart I-3No Stable Correlation Between EM Markets And U.S. Bond Yields No Stable Correlation Between EM Markets And U.S. Bond Yields No Stable Correlation Between EM Markets And U.S. Bond Yields Chart I-4EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys   Our macro views and themes have been positive for DM bonds. Fixed-income investors who favored U.S. Treasurys over EM local bonds have not underperformed by much in the past 12 months and have actually dramatically outperformed in 2018. Complacency Or A New Normal? There are two possible scenarios for EM domestic bonds going forward: Bullish Scenario: EM Local Bonds Have Entered A New Normal We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as EM currencies depreciate. This implies the past relationships between EM domestic yields on the one hand, and EM currencies and global macro variables on the other hand have permanently reversed. If EM domestic bonds have entered a New Normal, central banks in high-yielding EMs should cut interest rates during global growth slowdowns even if their exchange rate depreciates. Besides, their local bond yields should move lower despite currency weakness. If these two conditions are satisfied, one can argue that a major regime shift in EM interest rates has taken place. Ongoing rate cuts by a few of EM central banks - despite lingering weakness in their currencies - could be an indication that we are entering such a regime shift (Chart I-5). We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as EM currencies depreciate. We are open to accept this idea of a New Normal. Central banks in any economy where growth is slowing and inflation is low or falling should reduce interest rates even if their exchange rate depreciates. This will be a positive development for these countries, as it will make their monetary policy counter-cyclical - as it should be. One pre-condition for EM domestic bonds entering a New Normal is for the share of foreign investors holding of local currency bonds to decline. It is occurring at the margin in some countries. In Turkey, South Africa, Malaysia and Poland, the share of foreign investors in domestic bonds has fallen (Chart I-6). Yet, this phenomenon is not occurring in Indonesia, Russia, Colombia and Mexico. Chart I-5Rare Examples Of Rate Cuts Amid Currency Weakness Rare Examples Of Rate Cuts Amid Currency Weakness Rare Examples Of Rate Cuts Amid Currency Weakness Chart I-6Falling Share Of Foreign Investors Falling Share Of Foreign Investors Falling Share Of Foreign Investors   Negative Scenario: Investor Complacency Ends Chart I-7EM Currencies Correlate With Global Business Cycle And Commodities Prices bca.ems_wr_2019_10_24_s1_c7 bca.ems_wr_2019_10_24_s1_c7 Another potential explanation for the resilience of EM domestic yields to local currency depreciation is investor complacency: extremely low and negative bond yields in DM is inducing an unrelenting search for yields. As a result, investors are looking through EM currency depreciation, hoping it will be fleeting. Conditional on our view that EM currencies remain at risk of further depreciation panning out, EM local bonds are unlikely to avoid foreign outflows and higher yields under this scenario. This is especially true for the EM countries with high foreign ownership of local bonds. In theory, various macro forces such as expectations of domestic monetary policy, fiscal policy, inflation prospects, domestic business cycles, individual countries’ exchange rates as well as global interest rates should influence EM local bond yields. In reality, however, EM local yields have historically risen during periods of global business cycle downturns and falling commodities prices. The channel was via EM currencies, which depreciated during these periods (Chart I-7). Thereby, the primary driver for local bond yields has historically been swings in domestic exchange rates. In turn, the basis for this high sensitivity of EM domestic bond yields to their exchange rates has been due to the large share of foreign ownership. Table I-1 illustrates that the share of local currency government bonds held by foreign investors is high in the majority of EM countries. The exceptions are China, India, Korea, the Philippines and Chile. The data for Brazil are suspect. It is difficult to believe that foreigners own a mere 12% and declining share of Brazilian local currency bonds. Another potential explanation for the resilience of EM domestic yields to local currency depreciation is investor complacency: extremely low and negative bond yields in DM is inducing an unrelenting search for yields. As a result, investors are looking through EM currency depreciation, hoping it will be fleeting. What is critical, is that international investors care about the returns on their investments in U.S. dollars, euros or Japanese yen. Hence, they are very sensitive to exchange rates. Historically, foreign investors flee EM local bond markets when EM currencies depreciate, and vice versa. Chart I-8 illustrates the wide gap between total returns on EM domestic bonds in local currency and U.S. dollar terms. Table I-1Share Of Domestic Bonds Held By Foreign Investors EM Local Bonds: A New Normal? EM Local Bonds: A New Normal? Chart I-8EM Currencies Are Key To EM Local Bonds Volatility EM Currencies Are Key To EM Local Bonds Volatility EM Currencies Are Key To EM Local Bonds Volatility   In short, most investment return volatility in EM local bonds can be attributed to exchange rates – i.e., investments in EM local bonds have in practical terms constituted a bet on their exchange rates. If EM currencies experience another downleg, foreign investors’ patience might run out, causing a spike in EM local yields. Bottom Line: It is still early to conclude if a New Normal in EM domestic bonds has already taken hold. Only time will tell whether the recent decoupling between EM local bond yields and their currencies is due to an unrelenting search for yield or represents a paradigm shift. Reasons Why Local EM Yields Could Rise There are two macro risks to EM local bonds: 1.  A deepening/persisting growth slump in China Deteriorating Chinese domestic growth or a weaker RMB remain the key risks to the rest of the world. In brief, odds are high that China will continue exporting deflation to the rest of the world. Shrinking Chinese imports imply that the rest of the world’s export revenues emanating from their shipments to China are contracting (Chart I-9). A negative growth shock in EM economies that are exposed to China heralds both weaker currencies and lower interest rates. Given that high-yielding EM local bonds yields have risen historically during negative growth shocks, we are reluctant to chase these EM yields lower. This has been, and remains, our main thesis for high-yielding EM bond markets. 2.  Rising inflation in the U.S. Despite commentators’ preoccupation with global deflation and recession, U.S. core inflation is moving up. The equal-weighted average of various core measures presently stands at 2.2% and is drifting higher (Chart I-10). Chart I-9Chinese Imports Are Shrinking Chinese Imports Are Shrinking Chinese Imports Are Shrinking Chart I-10U.S. Core Inflation Is Above 2% And Rising U.S. Core Inflation Is Above 2% And Rising U.S. Core Inflation Is Above 2% And Rising   Besides, BCA Research’s U.S. wage tracker and unit labor costs have been accelerating (Chart I-11). The tight labor market in the U.S. suggest that risks to wages and unit labor costs and, ultimately, inflation are skewed to the upside. Chart I-11U.S. Wages And Unit Labor Costs Are Accelerating U.S. Wages And Unit Labor Costs Are Accelerating U.S. Wages And Unit Labor Costs Are Accelerating Unless U.S. growth slows much further, America’s fixed-income markets will at some point wake up to the reality of rising inflation. This will produce a shift up in the entire yield curve. Such a spike in U.S. Treasury yields will lead to a period of dollar strength and a selloff in overbought EM local bonds. Bottom Line: EM local bonds are discounting a goldilocks scenario. The two most likely risks that investors should monitor are a deepening growth slump in China and upside surprises in U.S. consumer price inflation.  Investment Strategy: Instituting A Buy Stop on EM Equities Given our negative stance on EM exchange rates, we have been receiving rates in EM countries where interest rates historically dropped amid currency deprecation. These include Korea, Chile and Mexico (the latter due to the value in local rates). For a dedicated EM local bond portfolio, our recommended overweights have been: Mexico, Russia, Central Europe, Chile, Korea and Thailand. Our underweights have been South Africa, Turkey, Indonesia, the Philippines and Argentina. Clients can always find our country allocation and trades for the EM local bond universe at the end of our weekly reports - please refer to page 14 - or on our website.  Also, gauging the direction of EM local bond yields is critical not only to fixed-income portfolio managers but to equity managers as well. Chart I-12 illustrates that EM equities rally when their domestic bond yields are falling. The failure of EM share prices to rally in recent months amid plunging EM local bond yields has been due to shrinking corporate profits. We are instituting a buy stop on the MSCI EM equity index at 1075. Any pick-up in EM domestic bond yields without recovery in EM corporate earnings will cause a major drop in EM equities. As to our EM equity strategy, our negative view is currently being challenged by the reaction of global share prices to negative profits and growth data releases. Despite very weak global trade and manufacturing data as well as downbeat profits from cyclical sectors, U.S. high-beta stocks and global cyclicals – an equal-weighted average of global industrials, materials and semiconductor stocks - have held up well (Chart I-13). Chart I-12EM Stocks Struggled Despite Falling Local Yields EM Stocks Struggled Despite Falling Local Yields EM Stocks Struggled Despite Falling Local Yields Chart I-13Global Cyclicals And U.S. High-Beta Stocks Are Holding Up Global Cyclicals And U.S. High-Beta Stocks Are Holding Up Global Cyclicals And U.S. High-Beta Stocks Are Holding Up   This could reflect investor complacency or it could be that the equity market is sensing an imminent recovery in global growth that we do not see in data. In particular, DM equities are at a critical juncture – not only the S&P 500 but also euro area stock prices are flirting with their previous highs (Chart I-14). Chart I-14Euro Area Stocks Are At Their Major Resistance Euro Area Stocks Are At Their Major Resistance Euro Area Stocks Are At Their Major Resistance If they relapse from here, it will signify a bear market. On the other hand, if these equity markets break out, it would suggest that a major upleg is in the making. Even though EM share prices are well below their previous highs, they are also at a make or break juncture. Therefore, we are instituting a buy stop on the MSCI EM equity index at 1075 (Chart I-15). If and when the EM stock index in dollar terms breaks decisively above this level, we will become cyclically bullish and recommend playing the rally. Chart I-15We Are Instituting A Buy Stop at 1075 on MSCI EM Index We Are Instituting A Buy Stop at 1075 on MSCI EM Index We Are Instituting A Buy Stop at 1075 on MSCI EM Index   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chile: Structural Equity De-Rating The latest violent protests in Chile have raised doubts about its socio-political and economic stability. As a result, Chilean share prices could be facing both absolute and relative (versus other EM bourses) de-ratings. We are downgrading this bourse from overweight to neutral within an EM equity portfolio, reiterating our short position in the peso versus the dollar, and continue to bet on lower rates and falling inflation cyclically, as discussed in great length in our recent report. Chilean stocks have always been among the most expensive within the EM universe due to the nation’s economic and socio-political stability. The violent protests now warrant a structural de-rating of equity valuations (Chart II-1). Chart II-1Chilean Share Prices: A Long-Term Perspective Chilean Share Prices: A Long-Term Perspective Chilean Share Prices: A Long-Term Perspective First, the government will be forced to adopt much more populist policies, such as the recently announced raise in minimum wages, pension payments and healthcare benefits. Unit labor costs for businesses are set to rise substantially, eating into corporate profit margins. Second, in line with more populist policies, larger budget deficits and structurally higher inflation will cause the long-end of the yield curve to rise. Higher interest rates will put downward pressure on equity multiples. Finally, equity investors will require a higher risk premium to invest in this bourse. Chile’s equity valuation premium versus EM overall will shrink. Bottom Line: The central bank will have to cut rates by a larger margin: continue receiving 3-year swap rates. A recession is unavoidable as business confidence will plunge and derail hiring and investments. Inflation will fall much further cyclically: bet on lower inflation by going long 3-year local currency bonds and shorting their inflation-linked counterparts. Continue shorting the peso versus the U.S. dollar. Downgrade the allocation to Chilean stocks from overweight to neutral within an EM equity portfolio. Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations