High-Yield

Highlights Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The key and necessary condition for a new secular EM bull market to emerge is the end of abundant financing. The latter is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. The cyclical EM outlook hinges on China’s business cycle. The slowdown in China is broad-based and will deepen. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. Feature As we head into 2019, the past decade is shaping up to be a lost one for emerging markets (EM) assets. In particular: EM stocks have underperformed DM markets substantially since the end of 2010 (Chart I-1). In absolute terms, EM share prices are at the same level as they were in early 2010. Chart I-1EM Equities Have Been Underperforming DM For Eight Years EM currencies have depreciated substantially since 2011, and the EM local currency bond index (GBI-EM) on a total-return basis has produced zero return in U.S. dollar terms since 2010 (Chart I-2). Chart I-2A Lost Decade For Investors In EM Local Currency Bonds? Finally, EM sovereign and corporate high-yield bonds have not outperformed U.S. high-yield corporate bonds on an excess-return basis. Will 2019 witness a major reversal of such dismal EM performance? And if so, will it be a structural or cyclical bottom? The roots underneath this lost decade for EM stem neither from trade wars nor from Federal Reserve tightening. Therefore, a structural bottom in EM financial markets is contingent neither on the end of Fed tightening nor the resolution of current trade tussles. We address the issues of Fed tightening and trade wars below. A Lost Decade: Causes And Remedies What led to a lost decade for EM was cheap and plentiful financing. When the price of money is low and financing is abundant, companies and households typically rush to borrow and spend unwisely. Capital is misallocated and, consequently, productivity and real income growth disappoint – and debtors’ ability to service their debts worsens. This is exactly what has happened in EM, as easy money splashed all over developing economies since early 2009. There have been three major sources of financing for EM: Source 1: Chinese Banks Chinese banks have expanded their balance sheets by RMB 198 trillion to RMB 262 trillion (or the equivalent of $28.8 trillion) over the past 10 years (Chart I-3, top panel). When commercial banks expand their balance sheets by lending to or buying an asset from non-banks, they create deposits (money). Consistently, the broad money supply has expanded by RMB 175 trillion to RMB 234 trillion (or the equivalent of $25.5 trillion). Chart I-3Enormous Boom In Chinese Banks' Assets And Money Supply Notably, the People’s Bank of China (PBoC) has increased commercial banks’ excess reserves by RMB 1.5 trillion to RMB 2.8 trillion (or the equivalent of $0.22 trillion) (Chart I-3, bottom panel). Hence, the meaningful portion of money supply expansion has been due to the money multiplier – money created by mainland banks – not a provision of excess reserves by the PBoC (Chart I-4). Chart I-4Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Not only has such enormous money creation by commercial banks generated purchasing power domestically, but it has also boosted Chinese companies’ and households’ purchases of foreign goods and services. The Middle Kingdom’s imports of goods and services have grown to $2.5 trillion compared with $3.2 trillion for the U.S. (Chart I-5). China’s spending has boosted growth considerably in many Asian, Latin American, African, Middle Eastern, and even select advanced economies. Chart I-5Imports Of Goods And Services: China And The U.S. Source 2: DM Central Banks’ QE By conducting quantitative easing, the central banks of several advanced economies have crowded out investors from fixed-income markets, incentivizing them to search for yield in EM. The Fed, the Bank of England, the European Central Bank and the Bank of Japan have in aggregate expanded their balance sheets by $10 trillion (Chart I-6). Chart I-6Quantitative Easing In DM This has led to massive inflows of foreign portfolio capital into EM, and reflated asset prices well beyond what was warranted by their fundamentals. Specifically, since January 2009, foreign investors have poured $1.5 trillion on a net basis into the largest 15 developing countries excluding China, Taiwan and Korea (Chart I-7, top panel). For China, net foreign portfolio inflows amounted to $560 billion since January 2009 (Chart I-7, bottom panel). Chart I-7Cumulative Foreign Portfolio Inflows Into EM And China Source 3: EM Ex-China Banks EM ex-China began expanding their balance sheets aggressively in early 2009, originating new money (local currency) and thereby creating purchasing power. This was especially the case between 2009 and 2011. Since that time, money creation by EM ex-China banks has decelerated substantially due to periodic capital outflows triggering currency weakness and higher borrowing costs. Out of these three sources, China’s money/credit cycles remain the primary driver of EM. The mainland’s imports from developing economies serves as the main nexus between China and the rest of EM. Essentially, Chinese money and credit drive imports, influencing growth and corporate profits in the EM universe (Chart I-8). Chart I-8China's Credit Cycle Leads Its Imports In turn, EM business cycle upturns attract international capital. Meanwhile, credit creation by local banks in EM ex-China – primarily in economies with high inflation or current account deficits – is a residual factor. In these countries, domestic credit creation is contingent on a healthy balance of payments and a stable exchange rate. The latter two, in turn, transpire when exports to China and international portfolio capital inflows are improving. The outcome of easy financing is over-borrowing and capital misallocation. The upshot of the latter is usually lower efficiency and productivity growth. Not surprisingly, productivity growth in both China and EM ex-China has decelerated considerably since 2009 (Chart I-9). EM return on assets has dropped a lot in the past 10 years and is now on par with levels last seen during the 2008 global recession (Chart I-10). Chart I-9Falling Productivity Growth In EM And China =... Chart I-10... = Low Profit Margins And Low Return On Capital Accordingly, the ability to service debt by EM companies has deteriorated considerably in the past decade – the ratios of cash flows from operations to both interest expenses and net debt have dropped (Chart I-11). Chart I-11EM: Deteriorating Ability To Service Debt These observations offer unambiguous confirmation that money has been spent inefficiently – i.e., misallocated. Credit booms and capital misallocations warrant a period of corporate restructuring and banking sector recapitalization. Without this, a new cycle cannot emerge. A secular bull market in equities and exchange rates arises when productivity growth and hence income-per-capita growth accelerates, and return on capital begins to climb. This is not yet the case for most developing economies. The end of cheap and abundant financing is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. These are necessary conditions to create the foundation for a new secular bull market. Ironically, the best remedy for an addiction to easy money is a period of tight money. For example, U.S. share prices would not be as high as they currently are if the U.S. did not go through the Lehman crisis. This 10-year bull market in U.S. equities was born from the ashes of the Lehman crisis. Vanished financing and the private sector’s tight budgets in 2008-‘09 compelled corporate restructuring as well as a focus on efficiency and return on equity. Has EM financing become scarce and tight? Cyclically, China’s money creation and credit flows have slowed, pointing to a cyclical downturn in EM share prices and commodities (please see below for a more detailed discussion). International portfolio flows to EM have also subsided since early this year. There has been selective corporate restructuring post the 2015 commodities downturn, including in the global/EM mining and energy sectors, China steel and coal industries as well as among Russian and Brazilian companies. However, there are many economies and industries where corporate restructuring, bank recapitalization and structural reforms have not been undertaken. Yet from a structural perspective, China’s money and credit growth remain elevated and excesses have not been purged. Besides, international portfolio flows to EM have had periodic “stop-and-gos” but have not yet retrenched meaningfully (refer to Chart I-7 on page 4). Consequently, structural overhauls and corporate restructuring in China/EM have by and large not yet occurred – in turn negating the start of a new secular bull market. Bottom Line: Conditions for a structural bull market in EM/China are not yet present. EM/China: A Cyclical Bottom Is Not In Place From a cyclical perspective, China is an important driving force for the majority of EM economies, and its deepening growth slowdown will continue to weigh on EM growth and global trade. In fact, odds are that global trade will contract in the first half of 2019: In China, tightening of both monetary policy as well as bank and non-bank regulation from late 2016 has led to a deceleration in money and credit growth. The latter has, with a time, lag depressed growth since early this year. Policymakers have undertaken some stimulus since the middle of this year, but it has so far been limited. Stimulus also works with a time lag. Besides, even though the broad money impulse has improved, the credit and fiscal spending impulse remains in a downtrend (Chart I-12). Therefore, there are presently mixed signals from money and credit. Chart I-12China's Stimulus Leads EM And Commodities As illustrated in Chart I-12, the bottoms in the money and combined credit and fiscal spending impulses, in July 2015, preceded the bottom in EM and commodities by six months and their peak led the top in financial markets by about 15 months in January 2018. Besides, in 2012-‘13, the rise in the money and credit impulses did not do much to help EM stocks or industrial commodities prices. Hence, even if the money as well as credit and fiscal impulses bottom today, it could take several more months before the selloff in EM financial markets and commodities prices abates. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend, and borrowers' readiness to borrow) and the velocity of money (the marginal propensity to spend among households and companies). Growth in capital spending in general and construction in particular have ground to a halt (Chart I-13). Chart I-13China: Weak Capital Spending Not only has capital spending decelerated but household consumption has also slowed since early this year, as demonstrated in the top panel of Chart I-14. Chart I-14China: A Broad-Based Slowdown Finally, mainland imports are the main channel in terms of how China’s growth slowdown transmits to the rest of the world. Not surprisingly, EM share prices and industrial metals prices correlate extremely well with the import component of Chinese manufacturing PMI (Chart I-15). Chart I-15China's Imports And EM And Commodities Bottom Line: The slowdown in China is broad-based, and our proxies for marginal propensity to spend by households and companies both point to further weakness (Chart I-14, middle and bottom panels). Constraints And Chinese Policymakers’ Dilemma Given the ongoing slowdown in the economy, why are Chinese policymakers not rushing to the rescue with another round of massive stimulus? First, policymakers in China realize that the stimulus measures of 2009-‘10, 2012-‘13 and 2015-‘16 led to massive misallocations of capital and fostered both inefficiencies and speculative excesses in many parts of the economy – the property markets being among the main culprits. Indeed, policymakers recognize that easy money does not foster productivity growth, which is critical to the long-term prosperity of any nation. For China to grow and prosper in the long run, the economy’s addiction to easy financing should be curtailed. Second, policymakers are currently facing a dilemma. The real economy is saddled with enormous debt and is slowing. This warrants lower interest rates – probably justifying bringing down short-term rates close to zero. Yet, despite enforcing capital controls, it seems the exchange rate has been correlated with China’s interest rate differential with the U.S. since early 2010 (Chart I-16). Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. Notably, the PBoC’s foreign exchange reserves of $3 trillion are only equivalent to 10-14% of broad money supply (i.e., all deposits in the banking system) (Chart I-17). Chart I-16Chinese Currency And Interest Rates Chart I-17China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits The current interest rate differential is only 33 basis points. If the PBoC guides short-term rates lower and the Fed stays on hold or hikes a few more times, the spread will drop to zero or turn negative. Based on the past nine-year correlation, the narrowing interest rate spread suggests yuan depreciation. This will weigh on EM and probably even global risk assets. In a scenario where policymakers prioritize defending the yuan’s value, they may not be able to reduce borrowing costs and assist indebted companies and households. As a result, the downtrend in the real economy would likely worsen. Consequently, EM and global growth-sensitive assets will drop further. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-bad outcome. Yet this will rattle Asian and EM currencies and risk assets. What About The Fed And Trade Wars? The Fed and EM: Fed policy and U.S. interest rates are relevant to EM, but they are of secondary importance. The primary driver of EM economies are their own domestic fundamentals as well as global trade – not just U.S. growth. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-18). On this chart, we have shaded the five periods over the past 38 years when EM stocks rallied despite a rising fed funds rate. Chart I-18The Fed And EM Share Prices: A Historical Perspective There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. Yet it is vital to emphasize that these crises occurred because of poor EM fundamentals – elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Trade Wars: China’s current growth slowdown has not originated from a decline in its exports. In fact, Chinese aggregate exports and those to the U.S. have been growing at a double-digit pace, largely due to the front running ahead of U.S. import tariffs. More importantly, China’s exports to the U.S. and EU account for 3.8% and 3.2% of its GDP, respectively (Chart I-19). Total exports amount to 20% of GDP, with almost two-thirds of that being shipments to developing economies. This compares with capital spending that makes up 42% of GDP and household consumption of 38% of GDP. Hence, capital expenditures and household spending are significantly larger than shipments to the U.S. Chart I-19Structure Of Chinese Economy There is little doubt that the U.S.-China confrontation has affected consumer and business sentiment in China. Nevertheless, the slowdown in China has - until recently - stemmed from domestic demand, not exports. Investment Recommendations It is difficult to forecast whether the current EM down leg will end with a bang or a whimper. Whatever it is, the near-term path of least resistance for EM is to the downside. “A bang” scenario – where financial conditions tighten substantially and for an extended period – would likely compel corporate and bank restructuring as well as structural reforms. Therefore, it is more likely to mark a structural bottom in EM financial markets. “A whimper” scenario would probably entail only moderate tightening in financial conditions. Thereby, it would not foster meaningful corporate restructuring and structural reforms. Hence, such a scenario might not mark a secular bottom in EM stocks and currencies. In turn, the EM cyclical outlook hinges on China’s business cycle. If and when Chinese policymakers reflate aggressively, the mainland business cycle will revive, producing a cyclical rally in EM risk assets. At the moment, Chinese policymakers are behind the curve. With respect to investment strategy, we continue to recommend: Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. For dedicated EM equity portfolios, our overweights are: Brazil, Mexico, Chile, Colombia, Russia, central Europe, Korea and Thailand. Our underweights are: South Africa, Peru, Indonesia, India, the Philippines and Hong Kong stocks. We are neutral on the remaining bourses. In the currency space, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR and KRW. The latter is a play on RMB depreciation. The full list of our recommendation across EM equity, fixed-income, currency and credit markets is available on pages 14-15. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights China’s old economy is set to decelerate in the first half of 2019, regardless of the recent tariff ceasefire. Our base case view is that growth will modestly firm in the second half of 2019, but timing the trough will depend on the dynamics of a battle between debt-focused policymakers and a credit-driven economy. Renewed weakness in China's currency has the potential to rekindle (and reinforce) the now-dormant concern of widespread capital flight. Investors should be alert to its re-emergence, as it would likely have implications for a broad range of financial assets (not just the exchange rate). A tactical overweight stance towards Chinese stocks (either the domestic or investable market) within a global equity portfolio is probably warranted over the coming three months. The conditions for a cyclical overweight stance (6-12 months) are not yet present but may emerge sometime in 2019, particularly if money & credit growth begin to pick up. Defaults in China’s onshore corporate bond market will rise next year, but will likely positively surprise investors. We continue to recommend a diversified position in this asset class for domestic investors and qualified global investors in hedged currency terms. Feature BCA recently published its special year end Outlook report for 2019,1 which described the macro themes that are likely to drive global financial markets over the coming year. In this week’s China Investment Strategy report we expand on the Outlook, by reviewing our four key themes for China in the year ahead. Key Theme # 1: The Battle Between Reluctant Policymakers And A Weakening Economy We presented a stylized view of China’s recent mini-cycle late last year (Chart 1), and argued that while an economic slowdown was underway it would most likely be a benign and controlled deceleration. Chart 1China’s Growth Profile Has Largely Been In Line With What We Forecasted Last Year… Chart 2 highlights that this view has broadly panned out, although the trade war with the United States has ironically (and only temporarily) boosted economic activity over the past several months. When measured by nominal GDP growth, the chart shows that the Chinese economy has retraced roughly 40% of the acceleration that occurred from late-2015 to early-2017, which is entirely consistent with the benign slowdown scenario that we presented a year ago. However, when measured by the Li Keqiang index, the chart shows that growth momentum stumbled quite significantly earlier this year, only to somewhat recover over the past two quarters. Chart 2...But Growth Stumbled In The First Half Of 2018 Chart 3 suggests that this recent recovery in the coincident data has been strongly driven by trade front-running. The chart shows an average of nominal Chinese import and export growth alongside growth in freight volume and manufacturing fixed-asset investment, and makes it clear that the recent pickup in activity has been due to persistently strong trade growth that is unlikely to continue. Chart 3Trade Front-Running Has Clearly Boosted Economic Activity This weekend’s short-term tariff ceasefire between the U.S. and China means that the trade shock will be of considerably reduced intensity than originally feared during the negotiation period. Nonetheless, the front-running effect is set to wane regardless of the existence of negotiations, implying that China’s old economy is set to recouple with our BCA Li Keqiang leading indicator in the first half of 2019. While the indicator has recently ticked up, this is almost entirely due to the recent depreciation in the RMB, as money and credit growth remain flat. For now, investors should focus on the level of the indicator, which is predicting a slowdown in economic activity over the coming several months (Chart 4). Chart 4A Slowdown In China's Old Economy Is Coming Our judgement is that a true deal between the U.S. and China next year that durably ends the trade war remains unlikely, although the odds have certainly increased as a result of this weekend’s announcement. But Chinese domestic demand had been slowing prior to the onset of the trade war, a fact that the market ignored until the middle of this year when it moved to price in both the underlying slowdown and the trade situation (Chart 5). This raises two questions: how much of a deceleration in growth will ultimately occur, and at what point will the economy bottom? Chart 5Investors Ignored A Slowing Economy Until The Trade War Emerged The answers to these questions are subject to the outcome of a battle between policymakers who are reluctant to push for sizeable releveraging, and an economy that appears to be strongly linked to money and credit growth. We have highlighted in several previous reports why Chinese policymakers want to avoid another sharp increase in the private-sector debt-to-GDP ratio,2 reasons that have solid grounding in both political and economic fundamentals and that become more pertinent if a trade deal between the U.S. and China is in fact negotiated. Still, Chinese policymakers, like those in any other country, will forcefully act to stabilize their economy (using whatever policy tools are required) if they conclude that conditions are about to deteriorate past the “point of no return”. Forecasting exactly when or whether this will occur is difficult, but both policymakers and investors will know more once the front-running effect on coincident activity wanes, and the true outlook for the external sector comes into view. For now, our base case view is that growth will modestly firm in the second half of 2019, which would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. We will be closely monitoring the incoming macro data in the first quarter of the year to judge whether it is consistent with our outlook. Key Theme # 2: Renewed Investor Scrutiny Of China’s Capital Controls Prior to the G20 summit, our expectation was that a break above the psychologically-important threshold of 7 for USD-CNY was imminent, likely in response to the escalation of the second round tariff rate to 25% on January 1. This catalyst has now clearly been deferred for the next three months, at least. However, Chart 6 shows that a resumption in the trade war is not the only source of potential weakness in the RMB. The chart illustrates the tight link between USD-CNY and the short-term interest rate differential between China and the U.S., and that the latter fell sharply in advance of the collapse in the former. Chart 6Interest Rate Differentials And USD-CNY: A Tight Link The true nature of the relationship between the two variables shown in Chart 6 remains a source of debate within BCA, as classic, open-economy interest rate arbitrage (the dynamic that enables currency carry trades) does not apply to countries that have officially closed capital accounts. But to the extent that the relationship holds over the coming year, Fed rate hikes alone have the potential for USD-CNY to rise above 7, as it would imply that the 1-year swap rate spread between the two countries will fall to zero (assuming no change in Chinese monetary policy). Regardless of the catalyst, renewed weakness in China's currency has the potential to rekindle (and reinforce) the narrative of capital flight that was last present following the August 2015 devaluation of the RMB. Global investor scrutiny of China's capital controls is likely to intensify significantly in such a scenario, and could contribute to negative investor sentiment towards China. As we noted in a September Weekly Report,3 several measures suggest that the capital flow crackdown that China initiated following the severe outflow pressures in 2015 and early-2016 has been successful. However, some other proxies of capital flight show persistent outflow since 2015 (Chart 7), with at least one measure having deteriorated rather significantly over the past few months. Chart 7Some Proxies Of Capital Flight Suggest Persistent Outflow Since 2015 Compiling an exhaustive inventory of different capital flow metrics (and their reliability) is part of our ongoing research efforts, and we hope to publish a Special Report on the topic early in 2019. For now, investors should be alert to any signs suggesting that a capital outflow narrative is becoming more prominent, as it is likely to have broader implications for financial markets than just the bilateral exchange rate. Key Theme # 3: Timing When (And Whether) To Go Long Chinese Stocks On A Cyclical Basis Many global investors are strongly focused on the question of when to go outright long Chinese stocks (either the domestic or investable market), on the basis of a substantial improvement in valuation, deeply oversold technical conditions, expectations of further action from policymakers, and a belief that the trade war with the U.S. will soon be resolved. This weekend’s agreement between the U.S. and China still does not make a trade deal probable,4 but we acknowledge that the odds have increased. This, coupled with the fact that Chinese stocks are still roughly 25% below their January high (Chart 8), suggests that a near-term sentiment-driven rally is possible. Over a 3-month time horizon, a tactical overweight stance towards Chinese stocks (either the domestic or investable market) within a global equity portfolio is probably warranted. Chart 8A Sentiment-Driven Rally Over The Next 3 Months Is Possible However, several points suggest that a long cyclical position (i.e. over a 6-12 month period) is currently pre-mature: We noted above that the Chinese economy is set to decelerate further over the coming several months, suggesting that earnings uncertainty is likely to rise. This, in combination with reactive policymakers, already-slowing earnings momentum, and the fact that 12-month forward earnings have only just started to be adjusted downward (Chart 9), suggests that investors have not yet observed the true point of maximum bearishness for Chinese stock prices. Chart 9The Earnings-Adjustment Process Is Only Beginning The 2014-2016 episode shows that China-related financial assets rallied prematurely in advance of a durable and broad-based improvement in the Chinese macro data, and the belief on the part of investors that a short-term rebound in Chinese stock prices over the coming 3 months is the beginning of a sustained upleg could be a repeat of this mistake. Chart 10 shows our BCA Market-Based China Growth Indicator compared with our Li Keqiang Leading Indicator, and shows that Chinese-related financial assets clearly jumped the gun in the first-half of 2015, and then lagged the improvement in the leading indicator. In the case of 2015, it was the August devaluation in the RMB that caused a severe deterioration in investor sentiment towards China; in the first-half of 2019, a failed attempt at a trade deal coupled with a further slowdown in domestic activity may do the same. Chart 10A Near-Term Rally Will Likely Fizzle, Like In 2015 While a near-term rally in CNY-USD may occur, the currency may come under renewed pressure if the interest rate differential effect shown in Chart 6 becomes the dominant driver of the exchange rate. For global investors managing their equity portfolios in unhedged terms, further declines in the RMB will negatively impact U.S. dollar performance. Finally, Chart 11 shows that, based on a trailing earnings and cash flow basis, the investable market is not as cheap relative to the global benchmark as it was in early-2016, casting some doubt on valuation as a rally catalyst. Undoubtedly, part of this discrepancy reflects the substantial rise in the BAT stocks (Baidu, Alibaba, Tencent) as a share of investable market capitalization, which are priced at a premium but also viewed by many investors as largely immune to a slowdown in China’s old economy. But the fact that the trade war largely reflects the decision of the Trump administration to crack down on Chinese technology transfer and intellectual property theft suggests that the market share of these companies could be negatively impacted by any successful trade deal, implying that a higher risk premium for the tech sector is warranted today than in the past. Chart 11Investable Stocks Aren't Massively Cheap We do not rule out the possibility that conditions will justify shifting to an overweight cyclical stance (6-12 month time horizon) for Chinese stocks sometime in 2019, particularly if money & credit growth begin to pick up. But for now, this is something that remains on our watch list for next year, rather than a recommendation to act on today. Key Theme # 4: Onshore Corporate Bonds – Position For Positive Default Surprises Our fourth theme for 2019 is a highly contrarian view that is, to some, at odds with our pessimistic view of the Chinese economy. BCA’s China Investment Strategy service has maintained a long China onshore corporate bond trade since June 2017, and we continue to recommend a diversified portfolio of these bonds for domestic investors and qualified global investors in hedged currency terms. The fear of sharply rising defaults stemming from refocused efforts to reform China’s financial system is the basis for the predominantly bearish outlook for onshore corporate bonds. The value of defaulted bonds reportedly rose to 100 Bn RMB in 2018, a sharp increase (of approximately 70 Bn RMB) from 2017,5 and many market participants have argued that defaults will be even higher next year. We do not dispute that China’s onshore corporate bond default rate is rising, and it is certainly possible that the rate will be even higher in 2019. To us, the problem with the bearish corporate bond narrative is that 100 Bn RMB amounts to a default rate of approximately 0.4%, whereas investors are pricing the onshore market for a 4-5% default rate over the coming year (Chart 12). In other words, domestic investors appear to be expecting over a tenfold increase in corporate defaults over the coming 12 months from what occurred this year, a scenario that we believe is extremely unlikely. Chart 12Allowing Market-Implied Default Rates To Occur Would Be A Huge Policy Error In our judgement, there is simply no way that policymakers can allow default rates on the order of what is being priced in to occur, as it would constitute an enormous policy mistake that would risk destabilizing the financial system at a time when officials are attempting to counter a domestic economic slowdown. In fact, we doubt that China’s typical policy of gradualism when liberalizing its economy and financial markets would allow default rates to rise from 0% to 4-5% over a year in any economic environment, particularly the current one. We therefore do not see a long recommendation favoring Chinese corporate bonds as being at odds with a slowing economy, because spreads are more than pricing in what is likely to be a modest worsening in corporate defaults. In short, defaults will rise, but will likely positively surprise investors. As a final point, our positive view towards the onshore corporate bond market should not be taken as a positive sign for the offshore US$ market. BCA’s Emerging Market Strategy service has recently reiterated its recommendation to position defensively within EM US$ sovereign and corporate bonds,6 and China accounts for roughly 1/3rd of the latter. Chart 13 highlights the difference in spread between the onshore and offshore market, the latter proxied by the Bloomberg Barclays China Corporate & Quasi-Sovereign index. The chart shows that the onshore market substantially led the offshore market in terms of pricing in a deterioration in credit fundamentals, with the latter only now starting to catch up to the former. As such, we have a clear preference for the onshore market, and would not argue against a bearish offshore corporate bond view. Chart 13Onshore Corporate Bonds Offer More Compelling Value Than Those Offshore   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Pease see BCA Special Report "Outlook 2019 Late-Cycle Turbulence," published on November 27, 2018. Available at cis.bcaresearch.com. 2      Pease see Geopolitical Strategy/China Investment Strategy Special Report “China: How Stimulating Is The Stimulus?,” published August 15, 2018; Geopolitical Strategy/China Investment Strategy Special Report “China: How Stimulating Is The Stimulus? Part Two," published August 15, 2018; and China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” published August 29, 2018. All available at cis.bcaresearch.com. 3      Pease see China Investment Strategy Weekly Report “Moderate Releveraging And Currency Stability: An Impossible Dream?," published on September 5, 2018, available at cis.bcaresearch.com. 4      Pease see Geopolitical Strategy Weekly Report “Trade Truce: Narrative Vs. Structural Shift?,” published December 3, 2018, available at gps.bcaresearch.com. 5      Please see “China Bond Defaults Surpass 100 Billion Yuan For 1st Time”, Bloomberg News, November 29, 2018. 6      Pease see Emerging Markets Strategy/Global Fixed Income Strategy Special Report “EM Corporate Health And Credit Spreads,” published November 22, 2018, available at gfis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

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

Special Report

Highlights Structurally, EM corporate leverage is elevated and the interest coverage ratio is low. Cyclically, China/EM growth slowdown will lead to corporate spread widening. Rising U.S. dollar corporate bond yields in EM herald lower share prices. The recent underperformance in Mexican financial markets versus their EM peers is not sustainable. We reiterate our overweight position in Mexico. In Indonesia, the central bank is attempting to fight the Impossible Trinity, a battle that by definition cannot be won. Investors should keep underweighting this market. Feature This report focuses on the corporate health of emerging market (EM) companies, as well as the outlook for corporate bonds. We review the key drivers behind credit spreads and provide an up-to-date snapshot of overall corporate health. We also illustrate the travails in China's offshore corporate bond market, which are of high importance to the broad EM outlook. With respect to scope of coverage and data comparability, please refer to Box 1. BOX 1 Data Relevance And Its Application As there is no aggregate financial dataset for EM corporate bond issuers, we use corporate financial data provided by Worldscope for the EM equity universe - the constituents of the MSCI EM equity index. While from an individual country perspective this makes a difference, from an EM sector perspective the differences are not substantial. Excluding the technology sector, it is often the case that the same companies have both publicly traded stocks and bonds. This is especially true in sectors such as basic materials, energy, industrials, telecom, utilities and financials. This is why, in this report, we focus our attention on sectors rather than countries, and why we examine the EM companies' financial health excluding technology and banks. Banks' relevant financial ratios vary greatly from those of non-banks. For the technology sector, the largest tech names in the equity space have minimal bonds outstanding, so using financial data from the equity space for credit analysis is inappropriate. In short, the analysis below on corporate health is pertinent to both equity and corporate bond investors. However, its emphasis is on creditworthiness and ability to service debt, which is more attuned to credit investors. Drivers Of EM Credit Spreads Cyclical swings in EM corporate and sovereign credit spreads are driven by changes in borrowers' revenues, cash flow and profits. Hence, the business cycle is one of the important drivers of corporate creditworthiness. When global and EM growth accelerate, revenue and free cash flow improve, causing credit spreads to narrow (Chart I-1). The EM business cycle drives EM sovereign spreads too (Chart I-2). Chart I-1EM Corporates: Cash Flow From Operations And Credit Spreads Chart I-2EM Sovereign Spreads Move In Tandem With Business Cycle This is why we spend a lot of time gauging the global business cycle outlook and cover this topic extensively in our reports. For now, the growth outlook for China/EM and global trade remains gloomy: Chart I-3China Is A Major Risk For EM Profits China's credit and fiscal spending impulse projects further weakness in the mainland's business cycle and EM corporate earnings (Chart I-3). China's slowdown is no longer limited to the industrial sector - household spending growth has downshifted considerably since early this year, as we discussed in last week's report.1 Weakening sales of consumer goods and autos in China are one of the primary reasons behind the ongoing slump in the global technology and semiconductor sectors. Consistently, plunging growth in Taiwanese electronics exports points to both weaker global trade and EM tech earnings in the months ahead (Chart I-4). In short, even though we have excluded technology from our analysis of corporate financial health, hardware tech companies' profits remain at risk. The latter is not relevant for EM corporate bond investors, but it is critical for the EM equity space. Chart I-4Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Other pertinent financial market indicators for EM credit spreads are commodities prices, EM exchange rates and EM local rates. The basis is as follows: (1) Energy and materials make up 25% of the J.P. CEMBI EM corporate bond index, and commodities prices drive their revenues and in turn credit spread fluctuations (Chart I-5, top panel); (2) Outside the resource sector, corporate bond issuers by and large do not feature exporters, and their capacity to service foreign currency debt is greatly affected by exchange rate movements (Chart I-5, bottom panel); (3) Financials make up 30% of the J.P. CEMBI EM corporate bond index, and their credit spreads are greatly influenced by domestic interest rates and banking system health (Chart I-6). We exclude financials from our corporate health analysis because their financial ratios differ vastly from those of non-financials. Chart I-5Drivers Of Credit Spreads: Commodities And Currencies Chart I-6EM Bank Credit Spreads Will Widen If Local Bond Yields Rise Overall, we expect global trade to weaken, commodities prices to drop further and EM currencies to depreciate. The latter will push up local interest rates. In turn, several EM banking systems remain saddled with bad assets from previous credit booms that have not been recognized, and banks have not been recapitalized. These factors point to a widening in bank credit spreads. All in all, EM corporate and sovereign spreads will widen further. A Snapshot Of EM Corporate Health The following financial ratios - which are calculated for EM companies excluding technology and financials - do not justify currently tight corporate spread. Leverage measured as net debt (total debt minus cash assets) divided either by EBITDA or cash flow from operation2 (CFO) remains elevated (Chart I-7, top panel). Among 9 sectors, only energy, basic materials and consumer discretionary have seen their leverage fall over the past two years. Chart I-7EM Corporate Health: Leverage And Interest Coverage Ratios Interest coverage ratios computed as EBITDA- or CFO- to- interest expense are well below their 2007 and 2011 levels (Chart I-7, middle panel). These figures corroborate that neither EM corporate indebtedness nor companies' ability to service debt using cash from operations is back to levels that prevailed before the global financial crisis in 2008 when EM financial markets were in a secular uptrend. Crucially, this is inconsistent with presently still-tight EM corporate spreads (Chart I-7, bottom panel). This mispricing, in our opinion, reflects the global search for yield that was induced by the crowding out of investors from DM bond markets by global central banks' QE programs. A contraction in corporate profits and cash flows from operation - for the reasons discussed above - will cause issuers' credit matrixes to deteriorate. With respect to cross-sectional analysis, Table I-1 presents interest coverage ratios (computed as an average of EBITDA- and CFO-to-interest expense ratios) for mainstream countries and all sectors. The cells in red present pockets of distress where the interest coverage ratio is below 3. The cells in blue illustrate segments where moderate financial stress is present: these are sectors with an interest coverage ratio of above 3 but below 5.5. Table I-1Interest Coverage Ratios On a positive note, the rally in commodities and cutbacks in capex have allowed energy and basic materials companies to drastically improve their leverage and interest coverage ratios in the past 2 years. However, even though their present financial health is great, their cash flow from operations is set to deteriorate again as commodities prices continue to relapse. The key motive behind our negative view on credit markets in Latin America, Russia, the Middle East and Africa - which is de facto the EM universe excluding emerging Asia - is because with the exception of Turkey, they are very exposed to commodities prices. As commodities prices drop and these nations' currencies depreciate, their sovereign and corporate credit spreads will widen. We are not implying that these issuers are facing default risks. Simply, lower revenues from commodities and higher debt servicing costs due to currency depreciation warrant a re-pricing of risk. Within credit portfolios, we recommend favoring defensive low-beta credit, excluding banks, versus riskier high-beta ones. We are underweight EM banks within the EM equity space and recommend the same strategy for the EM credit universe. Based on the matrix in Table I-1, credit portfolios should overweight consumer services, tech, energy and basic materials and underweight industrials, utilities and healthcare. China's Corporate Health And Credit Market There has been little deleveraging among Chinese companies. On the contrary, the country's massive credit and fiscal stimulus in 2016 bailed out many indebted companies, lifting corporate debt levels and augmenting the misallocation of capital. In particular: Chart I-8China's Corporate Debt Is Enormous China's corporate debt remains enormous, at $19.5 trillion, or RMB 140 trillion. It is the highest in the history of any country (Chart I-8). Some 95% of corporate debt is in local currency terms. My colleague Jonathan LaBerge from China Investment Strategy has calculated that Chinese state-owned enterprises' adjusted return on assets, has fallen below the cost of capital (Chart I-9). This indicates that these companies have for now exhausted profitable investment opportunities and should arguably scale back on their investment expenditures. Further borrowing and investing by these enterprises will augment the amount of bad assets held by Chinese banks and reduce the country's overall productivity and hence, potential growth. Yet, denying these debtors financing will result in a major slump in capex, and probably labor market weakness. Chart I-9Chinese SOEs: Capital Misallocation Chart I-10Leverage And Interest Coverage For Chinese Companies Dissecting sectoral data, indebtedness is elevated for industrials, utilities and property developers. Consistently, the interest coverage ratio is extremely low for industrials, utilities and property developers (Chart I-10). Financial health of Chinese materials has improved tremendously due to de-capacity reforms - the shutdown of excess capacity that has boosted both steel and coal prices. Interestingly, this has occurred at the expense of utilities and some other heavy consumers of steel and coal. Notably, steel and coal prices are beginning to relapse (Chart I-11). For reasons discussed in our previous report,3 these commodities prices will drop further and will hurt producers' cash flow and profits, causing their creditworthiness to deteriorate. Chart I-11Steel And Thermal Coal Prices Offshore corporate bond yields and spreads are surging, foreshadowing rising borrowing costs and reduced availability of financing (Chart I-12A). The problem is especially acute for property developers (Chart I-12B). In a nutshell, Chinese corporate U.S. dollar bond yields are at their highest levels of the past five-six years. The same is true for emerging Asian corporate bond issuers. Chart I-12AChinese Offshore Aggregate Corporate Bonds Chart I-12BChinese Offshore Property Developers Not only do Chinese corporate bonds now account for 32.5% of EM and 56% of emerging Asian corporate bond indexes, but investment expenditures by Chinese companies are also critical to companies elsewhere in Asia and globally. Chinese gross fixed capital formation accounts for 6% and 5.4% of global GDP in nominal and real terms, respectively. By contrast, these numbers are 4.6% and 4.3% for the U.S. We have deliberated at great length on why China's growth will likely continue to downshift, despite the policy stimulus, and we will not repeat our arguments today.4 The financial health of Chinese companies will worsen due to dwindling sales and cash generation. This, along with less credit/financing available onshore and offshore, will erode their capacity to undertake large investment expenditures. Consequently, capital expenditures in general and construction in particular will suffer substantially. This is the main rationale behind our negative view on resources, raw materials and industrials worldwide. Investment Observations And Conclusions Apart from Turkey and Argentina, there has been no liquidation and capitulation in EM assets in general and the credit space in particular. It would be unusual if this extended selloff ends without capitulation. EM credit markets appear technically vulnerable. In particular, the excess returns on EM sovereign and corporate bonds are splintering below their 200-day moving averages (Chart I-13). Odds are there will be more downside. Chart I-13A Bad Signal Rising U.S. dollar corporate bond yields in both EM overall and in emerging Asia herald lower share prices (Chart I-14). So long as the drop in U.S. Treasury yields is offset by widening EM credit spreads, EM corporate bond yields will continue to rise and EM share prices will sell off. However, as and when EM corporate (or sovereign) yields start falling, irrespective of whether because of declining U.S. Treasury yields or narrowing EM credit spreads, EM equity prices will rally. EM sovereign and corporate bond yields are an imperative indicator to watch for equity investors. Chart I-14Rising Corporate Yields = Lower Share Prices We continue to recommend defensive positioning in EM sovereign and corporate bonds. In terms of asset allocation, EM dollar-denominated sovereign and corporate bonds should not be compared with EM local currency bonds or equities or U.S. Treasurys.5 These are credit instruments, and they should be a part of a credit portfolio with U.S. and European corporate bonds. Credit portfolios should presently be underweight EM sovereign and corporate bonds relative to U.S. corporate bonds (Chart I-15A & Chart I-15B). Chart I-15AEM Sovereign Credit Versus U.S. Credit: Relative Excess Returns Chart I-15BEM Corporate Credit Versus U.S. Credit: Relative Excess Returns Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Mexico: Is The Underperformance Overdone? Despite having a sound macroeconomic backdrop,6 Mexican financial markets have lately substantially underperformed their emerging market peers due in large part to domestic politics. Odds are that Mexican risk assets will continue to sell off in absolute terms, especially given the broad turmoil in the EM universe, which we expect to continue. That said, the recent underperformance of Mexican markets versus their EM peers is overdone, and odds are that Mexican stocks, local bonds and sovereign credit will outperform their EM peers over the coming six to 12 months: First, the Mexican authorities have been pursuing orthodox macro policies, including very tight monetary and fiscal policies. The central bank hiked its policy rate again last week in the face of a currency relapse, and the fiscal stance has been tight. Currently, the real policy rate is 4% and the 10-year local currency government bond yield is 5.5%, both deflated by core consumer price inflation (Chart II-1, top and middle panel). Real rates are very high by historical standards and are now above most other EMs. Chart II-1Mexico: Tight Monetary And Fiscal Policies The government's non-interest expenditures deflated by core consumer price inflation have been contracting (Chart II-1, bottom panel). Such a tight monetary and fiscal policy mix will not change considerably with AMLO taking the office and it should benefit the currency. We expect the peso to start outperforming its EM peers on a total-return basis. Second, the Mexican peso is very cheap - close to one standard deviation below fair value, according to the unit labor cost-based real effective exchange rate (Chart II-2). The latter is our favorite currency valuation measure. Chart II-2The Mexican Peso Is Cheap Third, economic growth is improving, as the effects from monetary and fiscal tightening are diminishing (Chart II-3). This should at the margin support Mexican financial markets versus their EM peers where growth is slowing. Chart II-3Mexico: A Moderate Cyclical Recovery Fourth, Mexico's business cycle is much more leveraged to the U.S. economy than to China's. In line with our view that U.S. growth will fare better than China's growth, the Mexican economy will likely outperform other EMs that are more leveraged to China. Finally, an important rationale behind our recommendation to maintain an overweight stance on Mexico is that Mexican risk assets are defensive plays within the broad EM universe. In other words, whenever there is broad EM turbulence and an ensuing flight to quality, Mexican risk assets tend to outperform their EM peers. This is even more likely to happen now that Mexican sovereign spreads are already elevated and local currency government bonds offer a very attractive yield relative to other EMs (Chart II-4). Chart II-4Mexican Domestic And U.S. Dollar Bonds Offer Value Still, a few words are warranted on the recent domestic political developments. Our view is that the latest measures announced by the incoming administration regarding the new airport and banking fees are more indicative of a strategy to test the markets before the AMLO administration takes office, rather than declaring war against both markets and investors. It is noteworthy how fast the AMLO government came out after each of these announcements to calm investors. This suggests to us that fears of Mexico taking an irreversible sharp political turn to the left are overblown. AMLO is likely to be pragmatic and deliberate in the way he pushes forward his policies. In a nutshell, our bias is that these announcements represent an attempt by the AMLO administration to promote competition and reduce rent-seeking activities in the economy. This can be negative for shareholders of incumbent large companies, as it will hurt corporate profits of oligopolies. However, in the long term these polices will be positive for overall economic growth as they will reduce the cost of doing business, appease structural inflation and boost the nation's competitiveness. From a structural perspective, these policies are positive for the currency and local bonds. One way to play this theme is to favor small-cap over large-cap companies. Given the oligopolistic structure of some industries, Mexican large-cap companies are much more likely to be hurt by the incoming administration's open competition policies than small-cap companies. As such, small-caps will likely outperform large-caps in Mexico over at least the next six to 12 months (Chart II-5). Moreover, small-caps are currently trading at a significant discount compared to large-caps, with the former trading at multiples that are half of the latter. Chart II-5Mexico: Small-Caps Will Outperform Large-Caps Investment Conclusion Dedicated EM investors should overweight Mexican equities, local currency bonds and sovereign credit within their respective universes. Concerning the exchange rate, we are maintaining our long MXN / short ZAR position. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Indonesia: Defying The Impossible Trinity? Indonesian stocks are attempting to rally and have lately outperformed the EM equity benchmark. The outlook for this bourse remains negative and we recommend investors to fade this rally and outperformance. Critically, Indonesian domestic interbank rates and corporate U.S. dollar bond yields are rising. Historically, this is a negative signal for share prices (Chart III-1, rates and yields are shown inverted). Chart III-1Rising Rates/Yields = Falling Stocks Weakening rupiah and rising interest rates are forcing the central bank (BI) into a policy dilemma: Should it defend the currency and allow interest rates to rise further or should it cap interest rates and let the currency find a market equilibrium? It appears the BI is trying to do both - to stop the currency from depreciating, while also capping or bringing down interbank rates simultaneously. This defies the Impossible Trinity thesis which stipulates that a central bank of a country with an open capital account has to choose between controlling either the exchange rate or interest rates. On the surface, it would seem that the BI has been focused on targeting a stable rupiah. The monetary authorities have sold foreign exchange reserves (Chart III-2, top panel), and raised the key policy rate. Chart III-2Aggressive Monetary Policy Tightening... Selling of foreign exchange reserves is a form of tightening as it drains the banking system's excess reserves at the central bank. Shrinking interbank liquidity, however, pushes up interbank rates and borrowing costs (Chart III-2, bottom panel). Higher borrowings costs not only make the currency more appealing to investors, but they also curb domestic demand and, thereby, improve the current account balance. This is an ultimate mechanism of how policy tightening leads to exchange rate stability. Yet the full picture of BI's policies is a lot murkier. While on the one hand, the central bank has sold its foreign exchange reserves and hiked policy rates to defend the rupiah, it has also offset some of the tightening by injecting local currency reserves into the banking system. Chart III-3 shows that the BI purchased/redeemed back central bank certificates from commercial banks, which has led to a sharp increase in commercial banks' excess reserves. Chart III-3... And Liquidity Injections By Central Bank Central bank liquidity injections are akin to monetary easing aimed at capping or even bringing down interbank rates. Hence, they come as a contradiction to the central bank's restrictive policies. If the BI chooses to stabilize the rupiah, then interbank rates and borrowing costs in general will have to rise and the economy will take a hit. Corporate earnings will then contract which will be bearish for the equity market. If the central bank opts to cap interbank rates, it has to inject as much liquidity (excess reserves) into the banking system as required. In this scenario, the currency could depreciate triggering capital flight and selloffs in equity and local bond markets. The BI can continue the muddle-through policy - offsetting or sterilizing its foreign exchange interventions by turning the backdoor liquidity taps on. These injections of local currency liquidity into the banking system could encourage speculation against the rupiah and allow banks to lend more, maintaining robust imports and a large current account deficit. It is not certain, but if the market perceives that interest rates are lower than warranted, the currency could very well depreciate amid this policy mix. In this scenario, the result could be a mix of gradual currency depreciation and somewhat higher interest rates. Financial markets will still do poorly in dollar terms. Overall, odds are high that the rupiah will resume its depreciation and interest rates will move higher. Indonesia's balance of payment dynamics remain a risk to the exchange rate. The current account deficit is still large and exports are heading south (Chart III-4). Chart III-4Current Account Deficit Is Large First, Chart III-5 illustrates that the sharp slowdown in the average manufacturing PMIs of Japan, Korea, Taiwan and Germany are pointing to an imminent contraction in Indonesian export volumes. Chart III-5Exports Are Heading South Second, thermal coal prices seem to be breaking down. Chart III-6 shows that the stock price of Adaro - a large Indonesian coal producing company - has already fallen by 45% in U.S. dollar terms since January, and is heralding a dismal outlook for coal prices. Chart III-6Coal Prices Are To Break Down Lower coal prices will shrink Indonesia's coal export revenues. The latter accounts for 12% of total Indonesian exports. In terms of the outlook for banks, which is a key equity sector, their share prices have been surprisingly resilient. Rising interest rates, however, will cause their NPLs to move higher hurting banks' profits, and pulling their share prices down (Chart III-7). Chart III-7Bank Stocks Are At Risk Finally, overall Indonesian equity valuations are still not attractive either in absolute terms or relative to the EM benchmark. Meanwhile, foreigners own 32% of the equity market and 37% of local currency bonds. As the rupiah slides, foreigners will rush to the exits, amplifying the currency depreciation. Bottom Line: The path of least resistance for the rupiah is down. Continue underweighting Indonesian equities and bonds and continue shorting the rupiah versus the U.S. dollar. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "On Domino Effects And Portfolio Outflows," dated November 15, 2018, available at ems.bcaresearch.com. 2 Cash flow from operations represents net cash flow from operating activities & excludes net cash flow financing and investing activities. 3 Please see China Investment Strategy Special Report, "Revisiting China's De-Capacity Reforms," dated October 17, 2018, available at cis.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth," dated October 25, 2018, available at ems.bcaresearch.com. 5 Please see Emering Markets Strategy Weekly Report, "Strategic Asset Allocation For Emerging Markets," dated May 7 2013, available at ems.bcaresearch.com. 6 Please see Emerging Markets Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

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

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