Munis/S&L tax exempt

Special Report

Highlights Theme 1: Secular Stagnation Vs. Trumponomics. A larger deficit will cause Treasury yields to rise in 2017 and, for at least a while, it will appear as though secular stagnation has been conquered. Theme 2: A Cyclical Sweet Spot. Better growth and an accommodative Fed will create a sweet spot for risk assets in the first half of 2017. The Treasury curve will bear-steepen early in the year and transition to a bear-flattening only when long-dated TIPS breakevens reach the 2.4% to 2.5% range. Theme 3: Global Risks Shift From Bond-Bullish To Bond-Bearish. The trade-off between accelerating global growth and a stronger dollar will dictate the pace of next year's rise in Treasury yields. Be on the lookout for bond-bearish surprises from the ECB and BoJ in late 2017. Theme 4: Lingering Policy Uncertainty. Frequent spikes in the Global Economic Policy Uncertainty index are likely next year, probably warranting a policy risk premium in asset prices. The composition of the FOMC is another tail risk that bears monitoring. Theme 5: A Pause In The Default Cycle. Recovery in the energy sector will cause the uptrend in the default rate to reverse in 2017, but poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Theme 6: The Muni Credit Cycle Starts To Turn. The municipal credit cycle will take a turn for the worse in 2017, and muni downgrades could start to outpace upgrades later in the year. Theme 7: A Rare Opportunity In Leveraged Loans. The rare combination of rising LIBOR and elevated defaults will cause leveraged loans to outperform fixed-rate junk bonds in 2017. Feature In this Special Report, the last U.S. Bond Strategy report of the year, we present seven major investment themes that will drive U.S. fixed income market performance in 2017. Our regular publication schedule will resume on January 10 with the publication of our Portfolio Allocation Summary for January 2017. Theme 1: Secular Stagnation Vs. Trumponomics With 2016 almost in the books, it is clear that Treasury returns will likely be close to zero for the year. The total return from the Bloomberg Barclays U.S. Aggregate index will be only marginally better, in the neighborhood of 1% to 2% (see the Appendix at the end of this report for a detailed summary of U.S. fixed income returns in 2016). But these disappointing returns don't tell the whole story. Up until November 8, the Bloomberg Barclays Treasury and Aggregate indexes had returned 4% and 5% year-to-date, respectively (Chart 1). It was only then that the surprise election of Donald Trump caused investors to question many of the assumptions that had driven yields lower during the past several years. As of today, there is not much daylight between the market's expected path of the federal funds rate and the FOMC's own projections (Chart 2). This means that for below-benchmark duration positions to perform well going forward it is no longer sufficient to call for a convergence between the market's rate expectations and the Fed's dots, as we had been doing since July.1 For Treasury yields to rise going forward we must exit the regime of secular stagnation - one that has been characterized by serial downward revisions to the Fed's interest rate forecasts - and enter a new regime where improving global growth and Trumponomics lead to a series of faster-than-expected rate hikes and upward revisions to the Fed's dots. Chart 1Bond Market Returns In 2016 Chart 2Market Almost In Line With Fed What Is Secular Stagnation? For the purposes of the bond market we define secular stagnation based on the observation that in each cycle since 1980 it has required lower real interest rates to achieve the Fed's inflation target (Chart 3). The logical conclusion to be drawn is that the equilibrium real interest rate - the one that is consistent with steady inflation - must be in a secular downtrend. A paper published last year by the Bank of England (BoE),2 and discussed in detail by our own Bank Credit Analyst last February,3 identifies the drivers of this long-run decline in the equilibrium real rate and ranks them in order of importance. Chart 3This Is What Secular Stagnation Looks Like One key finding from the BoE's research is that expectations for lower trend growth account for only 100 bps of the 450 bps decline in global real yields since the mid-1980s. Increases in desired savings and decreases in desired investment for a given level of global growth account for the bulk of the decline (300 bps), while 50 bps of the decline remains unexplained (Table 1). Table 1The Drivers Of Secular Stagnation The most important factors identified in the paper include: Demographics: A lower dependency ratio (the non-working age population relative to the working age population) is associated with an increased desire to save. Inequality: The bulk of income gains during the past 35 years have accrued to the richest tiers of the population, the group that is most inclined to save rather than spend. EM Savings Glut: Since the 1990s many emerging market countries have increased foreign exchange reserves to guard against capital outflows, representing an extra source of demand for safe assets. Falling Capital Goods Prices: The relative price of capital goods has fallen about 30% since the 1980s. This means that less savings are required to undertake the same amount of investment. Less Public Investment: The reluctance of governments to pursue large-scale public investment projects has contributed an additional 20 bps of downside to global real yields. Spread Between Cost of Capital & Risk Free Rate: The expected cost of capital (measured using bank credit spreads, corporate bond spreads and the equity risk premium) has not fallen as much as the risk free rate during the past 30 years. This has made investment less sensitive to changes in the risk-free rate. Is Trumponomics The Solution? Can a Donald Trump presidency actually change any of these long-run factors? It is conceivable that fiscal policies focused on spurring capital investment could enhance the outlook for productivity growth and reverse some of the decline in potential GDP growth expectations. However, lower potential GDP growth expectations have also been driven by slower labor force growth, a trend that fiscal policy is powerless to address. On the plus side, the dependency ratio is likely to bottom in the coming years and the increased infrastructure investment that Trump has promised would certainly put upward pressure on rates. It is also possible that the watering-down of certain regulations might bring the cost of capital more in-line with the risk free rate. However, these potentially positive trends need to be weighed against increasingly isolationist trade and immigration policies that will hamper potential GDP growth, as well as proposed tax cuts that disproportionately target the highest income tiers. The latter will only exacerbate the impact of inequality on real yields. What's The Verdict? With so much uncertainty surrounding fiscal policy it is premature to declare the death of secular stagnation. However, secular stagnation will not be the dominant bond market theme in 2017. Amidst all the uncertainty, one thing that seems likely is that a Trump presidency will result in materially higher deficits next year and consequently more Treasury issuance. Chart 4Big Government Only A##br## Problem For Opposition With one party now in complete control of the Congress it is certain that government spending will increase next year. As our geopolitical strategists have repeatedly pointed out,4 lawmakers are only opposed to higher spending when they are not in power. Survey results show that this is also true of voters (Chart 4). Further, Moody's has estimated a range of outcomes for the federal deficit in 2017 based on how much of Trump's stated campaign agenda is implemented. These estimates range from 4.1% of GDP at the low end to 6% of GDP at the high end. This compares to 3.8% of GDP that was expected under current law.5 The greater supply of Treasury securities next year will offset some of the increased demand stemming from the excess of desired savings relative to investment. This will cause Treasury yields to move higher in 2017 and, for at least a while, it will appear as though the forces of secular stagnation have been conquered. Bottom Line: While Trumponomics will rule in 2017, the forces of secular stagnation are simply dormant and are likely to flare-up again in 2018 and beyond. Theme 2: A Cyclical Sweet Spot In the first half of 2017 the combination of improving economic growth and accommodative monetary policy will create a "sweet spot" for risk assets. The positive environment for risk assets will only end when Fed policy becomes overly restrictive. We expect that restrictive Fed policy will not be an issue until near the end of 2017. Above-Trend Growth Chart 5Contributions To GDP Growth Even prior to the election, U.S. economic growth appeared poised to accelerate in 2017. The main reason being that some of the factors that restrained growth in 2016 are shifting from headwinds to tailwinds (Chart 5). Consumer spending should continue to be a solid contributor to growth next year, just as in 2016. Surveys of consumer sentiment suggest we should even expect a modest acceleration (Chart 5, panel 1). Residential investment actually contributed negatively to real GDP in Q2 and Q3 of 2016 even though leading indicators remained firm. This drag is bound to reverse (Chart 5, panel 2). Government spending contributed almost nothing to growth in 2016 but is poised to accelerate next year based on trends in public sector employment. This does not even take into account the potential for more stimulative fiscal policy in 2017 (Chart 5, panel 3). Inventories were a large negative contributor to growth this year. History suggests that large inventory drawdowns tend to mean-revert fairly quickly (Chart 5, panel 4). Net exports exerted less of a drag on growth in 2016 than 2015 due to moderation in the pace of exchange rate appreciation. With the dollar still in a bull market, net exports will not be a significant driver of growth in 2017 (Chart 5, bottom panel). Nonresidential investment was also a large drag on growth in 2016 and should return to being a small positive contributor next year. First, most of the drag was related to lower capital spending from the energy sector (Chart 6). Now that oil prices have rebounded this drag will abate. Second, surveys of new orders have remained supportive (Chart 7, panel 1) and industrial production growth has rebounded off its lows (Chart 7, panel 2). The rebound in industrial production growth is also likely related to the recovery in energy prices. Chart 6Contribution To Nonresidential Fixed Investment Spending Chart 7Will Capex Return In 2017? The end of the drag from energy alone will be enough to make nonresidential investment a positive contributor to growth next year. The wildcard is that the easier regulatory backdrop under President Trump could unleash the animal spirits of the corporate sector and lead to even larger gains. While this outcome is obviously highly uncertain, there is some evidence that business optimism has already increased. The NFIB small business optimism index shot higher in November (Chart 7, bottom panel) and what's more, the NFIB's Chief Economist Bill Dunkelberg noted that "the November index was basically unchanged from October's reading up to the point of the election and then rose dramatically after the results of the election were known." Accommodative Monetary Policy Even with an improving growth outlook we expect the Fed will be slow to react with a faster pace of rate hikes, opting instead to nurture the recovery in inflation and inflation expectations until they are more firmly anchored around its target. With core PCE inflation still running at 1.7% - below the Fed's 2% target - and the 5-year/5-year TIPS breakeven inflation rate currently at 1.86% - well below the level of 2.4% to 2.5% consistent with the Fed's inflation target - there is no rush for the Fed to send a message that it will move aggressively to snuff out incipient inflationary pressures (Chart 8). Instead, the Fed will continue to send the message that there is no need to be aggressive given the downside risks, and will continue to be sensitive to any negative market response to more restrictive monetary policy. In other words, the "Fed put" is still in place. If risk assets start to sell off due to perceptions of overly restrictive monetary policy, the Fed will be quick to adopt a more dovish posture. The Fed will react in this manner at least until long-dated TIPS breakevens are firmly anchored in the range of 2.4% to 2.5%. It is only at that point that the Fed will be less concerned about negative market reactions to Fed tightening and more concerned with battling inflation. Further, it will take at least until the second half of next year for long-dated TIPS breakevens to return to target. This is because they will be held back by the slow uptrend in actual core inflation. The sensitivity of long-dated TIPS breakevens to core inflation has increased since the financial crisis (Chart 9). We posit that this is due to the zero-lower-bound on the fed funds rate. Prior to the financial crisis, with the fed funds rate well above zero, in the event of a deflationary shock investors would reasonably expect the Fed to offset that shock by easing policy. As such, the deflationary shock had a limited impact on long-dated breakevens. But when the fed funds rate is constrained at the zero-bound, there is reason to question whether the Fed can respond to a deflationary shock as in the past. Given the proximity of the fed funds rate to zero, realized inflation will be a much stronger determinant of long-dated breakevens in the current cycle. Chart 8Inflation Still Needs To Rise Chart 9Recovery In Breakevens Will Moderate Inflation Will Move Higher, But Only Slowly Inflation will continue to march higher in 2017, driven by a tight labor market and upward pressure on wage growth. With the unemployment rate already at 4.6% even modest employment gains can lead to exponential increases in wage growth (Chart 10). However, the pass-through from wage growth to overall price inflation is likely to be muted. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017 (Chart 11, panel 1). Core goods inflation (25% of core CPI) will also remain very low. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 11, panel 2), and so will stay depressed as long as the bull market in the dollar remains intact. Chart 10Wage Growth & Unemployment Chart 11Core Inflation By Component Historically, wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 11, bottom panel). This component, which accounts for 25% of core CPI, is where we expect the marginal change in inflation will come from. We expect that the current uptrend in core inflation will remain intact next year, but core PCE will not converge with the Fed's 2% target until late-2017. Investment Implications The combination of better economic growth and accommodative Fed policy is a fertile environment for risk assets, and we expect spread product will perform well in the first half of next year. At the moment, however, we advocate only a neutral allocation to investment grade corporate bonds and an underweight allocation to high-yield based on poor valuation (see Theme 5). Given the positive economic back-drop we will be quick to increase exposure if spreads widen in the near term. Long-dated TIPS breakevens will also continue to widen until they reach the 2.4% to 2.5% range that is consistent with the Fed's inflation target. As such, we remain overweight TIPS relative to nominal Treasury yields, even though the uptrend in breakevens is likely to moderate in the months ahead. We will likely downgrade TIPS in 2017, once long-dated breakevens reach our target in the second half of the year. The cyclical sweet spot of better growth and an easy Fed also means that the Treasury curve is likely to bear-steepen in the New Year. Historically, excluding periods when the Fed is cutting rates, the 2/10 Treasury curve tends to steepen when TIPS breakevens rise and flatten when they fall (Chart 12). Further, after last week's Fed meeting the 5-year bullet now looks very cheap on the curve (Chart 13). Chart 12Wider Breakevens Correlated With A Steeper Yield Curve Chart 13The 5-year Bullet Is Cheap On The Curve We expect Treasury curve steepening to persist next year until TIPS breakevens normalize near our target. At that point the bear-steepening curve environment will shift to a bear-flattening one. Investors should buy the 5-year bullet and sell a duration-matched 2/10 barbell to profit from curve steepening in the first half of next year and to take advantage of the cheapness of the 5-year bullet. Bottom Line: The combination of better economic growth and an accommodative Fed will create a sweet spot for risk assets in the first half of 2017. The Treasury curve will bear-steepen and TIPS breakevens will continue to rise. Curve bear-steepening will transition to bear-flattening once long-dated TIPS breakevens level-off in the 2.4% to 2.5% range. Theme 3: Global Risks Shift From Bond-Bullish To Bond-Bearish Alongside secular stagnation, the most important theme driving U.S. bond markets during the past several years has been the divergence in growth between the U.S. and the rest of the world. We have repeatedly pointed out that these global growth divergences have led to upward pressure on the dollar, and that a strong dollar necessarily limits the amount of monetary tightening that can be achieved through higher interest rates. The strong dollar thus serves as a cap on long-dated Treasury yields. This theme will remain very much intact for most of 2017, but will probably be less potent than in prior years. Our Global LEI diffusion index - a measure of global growth divergences - has moved firmly into positive territory. This makes it unlikely that we will see another dollar appreciation of the scale witnessed in 2014/15 (Chart 14). The fact that the U.S. is still leading the way in terms of growth means the bull market in the dollar will stay in place, but the appreciation will be less potent going forward. Still, from the perspective of Treasury yields, it will be important to monitor the trade-off between accelerating global growth on the one hand and a stronger dollar on the other. One tool we have devised to help guide us in this respect is our 2-factor Global PMI model (Chart 15). This is a model of the 10-year Treasury yield based on global PMI and bullish sentiment toward the U.S. dollar. A stronger global PMI puts upward pressure on the 10-year Treasury yield while, for a given level of global growth, an increase in bullish sentiment toward the dollar pressures the 10-year yield lower. Chart 14Global Growth Divergences ##br##Less Pronounced Chart 152-Factor Global ##br##PMI Model At present, this model tells us that fair value for the 10-year Treasury yield is 2.26%, well below current levels. This is one reason we tactically shifted to a benchmark duration stance on December 6 even though we expect yields to rise next year. Going forward we will continue to use this model to assess whether increasing global growth or a stronger dollar is dominating in terms of the impact on Treasury yields. Chart 16A Bond Bearish Surprise? Through the mechanism described above, the rest of the world will continue to be a bond-bullish force with respect to U.S. Treasury yields for most of 2017. However, near the end of 2017 it is possible that either the Eurozone or Japan could start to exert upward pressure on U.S. Treasury yields. This could occur if it seems likely that either economic bloc is poised to reach its inflation target and the market starts to discount an end to their extremely accommodative monetary policies. We have highlighted the risks of such events in prior reports, in the context of our Tantrum Theory of Global Bond Yields.6 The unemployment rate in the Eurozone is declining rapidly, but has historically needed to break below 9% before core inflation starts to rise (Chart 16, panels 1 & 2). If the current pace of above-trend growth in Europe is sustained throughout 2017 then higher inflation and the end of the European Central Bank's (ECB) asset purchases could become a risk to global bond markets late next year. However, even minor setbacks in growth would be enough to push this risk out to 2018. In Japan, although inflation is still well below the Bank of Japan's (BoJ) target, yen weakness suggests it should begin to rise (Chart 16, bottom panel). While the BoJ has promised to wait until inflation is above target before abandoning its yield curve peg, it is possible that near the end of next year, if inflation is much higher, the market will start to discount the eventual end of the BoJ's policy and cause global bonds to sell off. For now we would characterize these bond-bearish surprises from the BoJ and/or ECB as tail risks for the global bond market that could flare in late 2017. Bottom Line: The trade-off between accelerating global growth and a stronger dollar will dictate the pace of next year's rise in Treasury yields. Be on the lookout for bond-bearish surprises from the ECB and BoJ in late 2017. Theme 4: Lingering Policy Uncertainty With fiscal policy having the potential to drastically alter the economic landscape and yet with so much still unknown about what will occur, lingering policy uncertainty will undoubtedly be a major theme for fixed income markets in 2017. Historically, the Global Economic Policy Uncertainty index created by Baker, Bloom and Davis7 has been a reliable gauge of these risks and has also tracked asset prices surprisingly well (Chart 17). Recently, the uncertainty index has spiked and asset prices have not responded in kind. This is likely a signal that the spike in uncertainty will quickly reverse, but it could be a signal that asset prices are overly complacent. At the very least the spike in uncertainty highlights the fact that bond markets have been very quick to discount the potentially positive impacts of a Trump presidency, but are at risk if these policies are not delivered. This lack of a "policy risk premium" in fixed income markets is driven home by the reading from our 3-factor Global PMI model (Chart 18). This model adds the Global Economic Policy Uncertainty index to the 2-factor Global PMI model mentioned in the previous section, increasing the explanatory power of the model in the process. At present, the 3-factor model gives a fair value reading of 1.82% for the 10-year Treasury yield. Chart 17Economic Policy Uncertainty & Bond Markets Chart 183-Factor Global PMI Model While the most recent spike in policy uncertainty may reverse before asset prices respond, the volatile nature of the incoming administration means that more frequent spikes of the uncertainty index are likely in 2017. At some point asset prices will probably react. There is another political risk in 2017 that carries extra importance for bond markets. In 2017 President Trump will appoint two new Fed Governors. Also, there is a good chance that Janet Yellen and Stanley Fischer will not be re-appointed as Chair and Vice-Chair respectively when their terms expire in early 2018. Given the pedigrees of Trump's economic advisors, we would expect the newly appointed Governors in 2017 to have hawkish policy leanings. While this will not significantly alter Fed decision making in 2017, since the core members of the Committee will still be in place, there is a risk that the market will anticipate that one of the newly appointed Governors will be Janet Yellen's eventual replacement. If that Governor is hawkish, then there is a risk that the market will start to discount a much more hawkish Fed reaction function as early as next year. This could potentially speed up the transition from a bear-steepening curve environment to a bear-flattening environment, putting spread product at risk earlier than we currently anticipate. The MBS market would also be at risk in this scenario, since any incoming hawkish Fed Governor would be very likely to favor an unwind of the Fed's balance sheet at a much quicker pace than is currently anticipated. We already recommend an underweight allocation to MBS due to low spread levels and a continued recovery in the housing market that will keep net issuance trending higher. A change of leadership at the Fed represents an additional tail risk. Although we think it is premature to say for certain that Chair Yellen and Vice-Chair Fischer won't be re-appointed in 2018, the key risk for next year is that the market anticipates that they will be replaced. Bottom Line: Frequent spikes in the Global Economic Policy Uncertainty index are likely next year, probably warranting a policy risk premium in asset prices. The composition of the FOMC is another tail risk that bears monitoring. Theme 5: A Pause In The Default Cycle The uptrend in the trailing 12-month speculative grade default rate will reverse in 2017, falling from its current 5.6% back closer to 4%. But this will only be a temporary reprieve and the uptrend will resume in 2018 and beyond. Increases in job cut announcements, contractions in corporate profits and tightening C&I lending standards all tend to coincide with a rising default rate (Chart 19). All three of these factors signaled rising defaults last year, but have since rolled over. We have often drawn a comparison between the current default cycle and the default cycles of the mid-1980s and mid-1990s, and this comparison is still apt. Chart 19The Current Default Cycle Is A Hybrid Of the Mid-1980s and Late-1990s Distress in the energy sector caused a contraction in corporate profits and rising defaults in 1986. But then a sharp easing of Fed policy and a recovery in oil prices caused the uptrend in defaults to reverse. Corporate profit contraction, increasing job cut announcements and tighter lending standards also caused the default rate to trend higher in 1998. This time, however, Fed policy remained restrictive (Chart 19, bottom panel) and banks had no incentive to ease lending standards amidst a back-drop of rising corporate leverage. The default rate continued to trend higher in the late 1990s, and did not peak until the next recession. While the energy price shock and subsequent recovery make the current cycle similar to the 1980s episode, the fact that the Fed is more inclined to hike than cut rates brings to mind the late 1990s. This leads us to believe that the recovery in energy prices will cause the default rate to fall next year. This, along with better economic growth and a relatively accommodative Fed, will keep downward pressure on credit spreads throughout most of 2017. However at some point, likely after TIPS breakevens have recovered to pre-crisis levels, the Fed's tone will turn decidedly more hawkish. This will lead to renewed tightening in lending standards, a resumption of the uptrend in defaults and wider corporate spreads. Despite our optimism about the macro outlook for 2017 we cannot forget that corporate balance sheet health continues to deteriorate (Chart 20). Our Corporate Health Monitor has been in 'deteriorating health' territory since 2013, and although corporate spreads have tightened since February they have yet to regain their 2014 lows. Additionally, net leverage for the nonfinancial corporate sector - defined as outstanding debt less cash on hand as a percent of EBITDA - is still trending higher (Chart 20, bottom panel). The only other period since 1973 when corporate spreads narrowed as net leverage increased was following the oil price crash and default spike of 1986. In that period spreads remained under downward pressure for approximately two years but never regained their prior lows. Spreads also benefitted from Fed rate cuts and a weakening dollar during that timeframe. In our view, the best way to play the corporate bond market in the current cycle is to maintain a cautious long-term bias but to look for attractive opportunities to initiate overweight positions. At the moment, we are actively looking to upgrade our allocation to corporate bonds but need a more attractive entry point first. At 405 bps, the average spread on the Bloomberg Barclays High-Yield index is only 65 bps above the average level observed in the 2004 to 2006 period when our Corporate Health Monitor was deep in 'improving health' territory. Not surprisingly, the spread appears even lower after adjusting for expected default losses (Chart 21). Chart 20Corporate Balance Sheets Continue To Add Leverage Chart 21Corporate Bond Valuation The default-adjusted high-yield spread is our preferred valuation measure for high-yield and investment grade corporate bonds alike. As is shown in Charts 22 and 23, the current default-adjusted spread of 162 bps is consistent with negative excess returns for both investment grade and high-yield bonds, on average, over a 12-month investment horizon. Chart 2212-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Chart 2312-Month Excess Investment Grade Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) However, this average negative excess return is heavily influenced by a few periods when excess returns were deeply negative. A more detailed examination, shown in Tables 2 & 3, reveals that when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns for high-yield have been positive 65% of the time. Investment grade excess returns have been positive only 35% of the time with spreads at current levels, but have been positive 55% of the time when the default-adjusted spread is between 100 bps and 150 bps. Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Table 312-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Given our optimistic assessment of the macro back-drop, we conclude that excess returns for both investment grade and high-yield corporate bonds are likely to be positive, but very low, during the next 12 months. But we will continue to look for opportunities to upgrade our allocation to spread product from more attractive levels. Bottom Line: The improving macro back-drop means that the default rate will move lower in 2017. However, the poor state of corporate balance sheets means that the default rate will likely resume its uptrend in 2018, once Fed policy turns decidedly more hawkish. Theme 6: The Muni Credit Cycle Starts To Turn Back in October, we published a Special Report 8 wherein we observed that Municipal / Treasury (M/T) yield ratios tend to fluctuate in long-run cycles determined by ratings downgrades and net borrowing at the state & local government level. That is, there exists a municipal bond credit cycle much in the same way that there exists a corporate credit cycle. Additionally, we introduced a Municipal Health Monitor - a composite indicator of the health of state & local government finances - to help us assess the stage of the municipal credit cycle and observed that it has tended to follow our Corporate Health Monitor with a lag of approximately two years (Chart 24). Chart 24The Municipal Credit Cycle Lags The Corporate Cycle This analysis leads us to believe that our Municipal Health Monitor will move into 'deteriorating health' territory at some point during 2017 and that municipal bond downgrades could start to outpace upgrades late next year. As such, we adopt a cautious stance with respect to the municipal bond market, not least of which because of the potentially negative impact on the market from a Donald Trump presidency. Lower tax rates next year will certainly undermine the tax advantage of municipal debt, while the potential for increased infrastructure spending could lead to a sizeable increase in municipal bond supply. Historically, most public investment has been financed at the state & local government level, and while Trump's current infrastructure plan relies entirely on incentives for private sector investment, these details could change before any plan is implemented. By far the largest risk to the municipal bond market would be if the municipal tax exemption is done away with entirely in the context of broader tax reform, but this now appears unlikely. Even in the absence of a federal government initiative we would not rule out increased state & local government investment next year. State & local government finances have made substantial progress since the crisis and many states are now in a position where they may start to loosen the purse strings (Chart 25). This poses an upside risk to muni supply in 2017. Of course, we have already seen large fund outflows in response to Trump's election victory. ICI data show that net outflows from municipal bond funds have totaled $14.86 billion since the end of October, and while M/T yield ratios have risen, they remain near the middle of their post-crisis trading ranges (Chart 26). Chart 25Healthy Enough To Invest Chart 26Municipal / Treasury Yield Ratios We will continue to look for opportunities to upgrade municipal bonds when the reading from our tactical Muni model turns more positive (Chart 27). This model- based on policy uncertainty, issuance, fund flows and ratings migration - shows that M/T yield ratios are not yet attractive. This is true even if we assume that last month's spike in policy uncertainty is completely reversed. This model has a strong track record of predicting Muni excess returns since 2010 (Table 4). Chart 27Tactical Muni Model Table 4Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 Bottom Line: The municipal credit cycle will take a turn for the worse in 2017, and muni downgrades could start to outpace upgrades later in the year. Remain underweight for now, but look for near-term tactical buying opportunities in municipal bonds. Theme 7: A Rare Opportunity In Leveraged Loans Chart 28Leveraged Loans Will Outperform In 2017 Our final theme for 2017 relates to the potential for floating rate leveraged loans to outperform fixed rate high-yield bonds. Historically, these periods of outperformance have been few and far between. There have only been two periods since 1991 when loans have outperformed bonds for any length of time (Chart 28). However, we believe that the conditions are in place for loans to outperform fixed-rate junk in 2017. There are two factors that can potentially cause leveraged loans to outperform fixed-rate junk. The first is rising LIBOR, which causes loan coupon payments to reset higher. While there is some concern that LIBOR floors prevent loans from benefitting from higher LIBOR, most loans have LIBOR floors of 75 bps or 100 bps. With 3-month LIBOR already at 99 bps, LIBOR floors will not be a constraint for much longer. The second factor that could cause loans to outperform bonds is an elevated default rate. Since loans are higher-up in the capital structure than bonds, they benefit from higher recovery rates. This matters more in terms of relative performance when the default rate is high. It is highly unusual for elevated defaults and rising LIBOR to coincide. This is because the Fed is typically cutting rates when the default rate is rising. However, next year, much like in the late 1990s, both conditions are likely to be in place. Bottom Line: The rare combination of rising LIBOR and elevated defaults will cause leveraged loans to outperform fixed-rate junk bonds in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com 2 Lukasz Rachel & Thomas D. Smith, "Secular Drivers of the Global Real Interest Rate (Staff Working Paper No. 571)", Bank of England, December 2015. 3 Please see Bank Credit Analyst Special Report, "Secular Stagnation And The Medium-Term Outlook For Bonds", dated February 25, 2016, available at bca.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 Mark Zandi, Chris Lafakis, Dan White and Adam Ozimek, "The Macroeconomic Consequences of Mr. Trump's Economic Policies", Moody's Analytics, June 2016. 6 Please U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 7 For further details on the construction of this index please see www.policyuncertainty.com 8 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Appendix: U.S. Bond Market 2016 Risk/Return Summary Chart A-1U.S. Bond Returns In Historical Context Chart A-22016 Total Returns Versus Volatility Chart A-32016 Vol-Adjusted Total Returns Chart A-42016 Excess Returns Versus Volatility Chart A-52016 Vol-Adjusted Excess Returns Chart A-62016 Corporate Sector Excess Returns Versus Duration-Times-Spread Chart A-7The Performance Of Our Corporate Sector Model In 2016

Highlights Chart 1More Upside From Inflation We moved to below benchmark duration on July 19, when the 10-year Treasury yield was 1.56%. As of last Friday's close, the 10-year Treasury yield was 2.4% and above the fair value reading from our global PMI model. While our economic outlook still justifies higher Treasury yields on a 12-month horizon, the selloff in bonds has moved too far, too quickly. We recommend tactically shifting to a benchmark duration stance. Longer run, the upside in Treasury yields will be concentrated in the inflation component. The cost of 10-year inflation compensation can rise another 49 bps before it is consistent with the Fed's target. But that adjustment will proceed gradually next year, alongside a shallow uptrend in realized inflation (Chart 1). Higher inflation compensation can occasionally be offset by lower real yields, but this only occurs when the increase in inflation compensation results from an easing of Fed policy, as in 2011-2012. With the Fed in the midst of a hiking cycle, the downside in real yields is limited. We would not be surprised to see the 10-year Treasury yield re-visit the 2%-2.2% range during the next month or two. At that point we would re-initiate a below benchmark duration stance, on the view that the 10-year yield will reach 2.80%-3% by the end of 2017. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in November. The index option-adjusted spread tightened 3 bps on the month and, at 129 bps, it is now slightly below its historical average (134 bps). Spread per unit of gross leverage1 for the nonfinancial corporate sector is slightly above its historical average (Chart 2). But unusually, spreads have been tightening this year despite sharply rising gross leverage. Since 1973, there has only been one other period when spreads tightened despite rising gross leverage. That was in 1986-88 when, similar to today, spreads were tightening from extremely oversold levels. Much like today, elevated spreads in 1986 resulted from distress in the energy sector that dissipated as oil prices recovered. This caused corporate spreads to widen dramatically and then tighten, while in the background gross leverage persistently climbed higher. The current recovery in oil prices could lead to further corporate spread tightening early next year. Indeed, energy sector credits still appear cheap on our model and we continue to recommend overweighting those sectors. This month we also upgrade Paper from neutral to overweight (Table 3). Table 3Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* However, corporate credit fundamentals are deteriorating rapidly and spreads will be at risk when the Fed adopts a more hawkish policy stance, possibly as early as the second half of next year.2 High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 128 basis points in November. The index option-adjusted spread tightened 23 bps on the month and, at 450 bps, it is 71 bps below its historical average. A model based on lagged spreads and default losses explains more than 50% of the variation in 12-month excess junk returns. This model currently forecasts excess junk returns of close to zero during the next 12 months (Chart 3), a forecast that is based on our expectation of a modest improvement in default losses (bottom panel). In a recent report,3 we examined the relationship between default-adjusted spreads and excess junk returns in more detail. We showed that a model based purely on ex-ante estimates of default losses explains around 34% of the variation in excess junk returns. We also showed that, historically, negative excess returns to junk bonds are only likely if the ex-ante default-adjusted spread is below 100 bps. Our current ex-ante default-adjusted spread is 201 bps. Historically, when the ex-ante default-adjusted spread is between 200 bps and 250 bps, junk earns positive excess returns 81% of the time. However, junk earns positive excess returns only 65% of the time if the spread is between 150 bps and 200 bps. Although our economic outlook for next year is fairly optimistic, high-yield valuations are stretched and we expect to get a better entry point from which to upgrade the sector during the next couple of months. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in November. Other than municipal bonds, MBS has been the worst performing fixed income sector relative to Treasuries, earning year-to-date excess returns of -17 bps. The conventional 30-year MBS yield rose 53 bps in November, driven by a 59 bps increase in the rate component. The compensation for prepayment risk (option cost) declined 10 bps, while the option-adjusted spread widened by 4 bps. Prior to the election, we had been tactically overweight MBS on the view that higher Treasury yields would lead to a lower option cost, benefitting MBS in the near term. Now that Treasury yields have moved substantially higher, our focus returns to the extremely depressed levels of MBS option-adjusted spreads (Chart 4). Extremely low option-adjusted spreads coupled with a housing market that should continue to recover - leading to steadily increasing net supply (bottom panel) - make for a poor risk/reward trade-off in MBS relative to other fixed income sectors. Against this back-drop, MBS are only worth a tactical trade if you have high conviction that Treasury yields are about to rise and option costs about to tighten. We do not expect the Fed to cease the reinvestment of its MBS purchases in 2017. But, if Janet Yellen is replaced as Fed Chair in early 2018, then it is possible that the new Fed will seek to end its involvement in the MBS market. This is a tail risk for MBS in 2018. Government Related: Overweight Chart 5Government Related Market Overview The government-related index underperformed the duration-equivalent Treasury index by 19 basis points in November (Chart 5). Domestic Agency bonds and Local Authority bonds outperformed the Treasury index by 2 bps and 61 bps, respectively. Sovereign debt underperformed by 122 bps, Foreign Agency debt underperformed by 54 bps and Supranationals underperformed by 6 bps. More than half of the underperformance in the Foreign Agency sector came from Mexico's state oil company, Pemex, in the aftermath of Donald Trump's election win. Losses in the Sovereign debt sector were similarly concentrated in Mexican issues. Strength in oil prices should permit Foreign Agency debt to outperform going forward, while the strong U.S. dollar will remain a drag on Sovereign debt. Local Authority and Foreign Agency debt both continue to offer attractive spreads relative to U.S. investment grade corporate bonds, after adjusting for duration and credit rating. In contrast, Supranationals and Sovereigns both appear expensive. We continue to recommend an underweight allocation to Sovereign debt within an otherwise overweight allocation to the government related sector. Bullet Agency issues outperformed callable Agency bonds in November, despite the large increase in Treasury yields (bottom panel). We expect this trend will soon reverse, and remain overweight callable versus bullet Agencies. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration equivalent Treasury index by 83 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio rose from 99% to 107% in November, and is now above its post-crisis average (Chart 6). We downgraded municipal bonds to underweight on November 15,4 following Donald Trump's election victory. Lower tax rates under the new administration will undermine the tax advantage in municipal bonds, leading to outflows and higher M/T yield ratios. ICI data show that outflows have already begun. Net outflows from Muni funds have exceeded $7 billion in the four weeks since the end of October (panel 4). There are also longer-run concerns related to supply and state & local government credit quality. Depending on how it is structured, increased infrastructure spending next year could lead to a large increase in municipal bond supply. Also, state & local government downgrades are likely to increase later next year, following the lead of the corporate sector. Both of these issues are discussed in more detail in a recent Special Report.5 In October, the SEC finalized new liquidity management standards for open-ended investment funds. Funds must now determine a minimum percentage of net assets that must be invested in highly liquid securities, and no more than 15% of assets can be invested in securities deemed illiquid. At the margin, the new rule could limit funds' appetites for municipal bonds. Treasury Curve: Laddered Chart 7Treasury Yield Curve Overview November's bond rout was concentrated in the belly (5-10 years) of the Treasury curve. The 2/10 Treasury slope steepened 28 basis points on the month, while the 5/30 slope flattened by 8 bps. We believe that the yield curve has room to steepen further in 2017, based largely on the expectation that the Fed will maintain an accommodative stance of monetary policy at least until TIPS breakeven inflation rates are at levels more consistent with the Fed's 2% inflation target (Chart 7). In our view, this level is between 2.4% and 2.5% for long-dated TIPS breakevens. However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. Although we view a "dovish hike", i.e. an increase in the fed funds rate with no upward revision to the Fed's interest rate forecasts, as the most likely outcome. If we are wrong, an upward revision to the Fed's forecasts would cause the curve to bear-flatten on the day. At present, the market expects 55 bps of rate hikes during the next 12 months (panel 1). If expectations remain at these levels until after next week's FOMC meeting they will be consistent with the Fed's median forecast, assuming there are no upward revisions. Also, as we pointed out on the front page of this report, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 148 bps in November. The 10-year breakeven rate increased 21 bps on the month, and currently sits at 1.91%. The 5-year, 5-year forward TIPS breakeven inflation rate has risen to 2.06% from its early 2016 trough of 1.41%. However, it still has room to rise before it returns to levels that are consistent with the Fed's 2% target for PCE inflation (Chart 8). As economic growth improves next year the Fed will be keen to allow TIPS breakevens to rise toward its target, and will be slow to shift to a less accommodative policy stance. As such, we maintain our recommendation to overweight TIPS relative to nominal Treasuries, with a target of 2.4% to 2.5% for the 5-year, 5-year forward TIPS breakeven rate. While breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. With the Fed in the midst of a tightening cycle, it will be difficult for the Fed to lead inflation expectations sharply higher as in past cycles. Trends in realized inflation will be more important for long-dated breakevens this time around. Core and trimmed mean PCE inflation continue to grind slowly higher, a trend that is supported by the PCE diffusion index (panel 4). Assuming the current trend remains in place, core PCE inflation should finally reach the Fed's 2% target before the end of next year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in November, bringing year-to-date excess returns up to +111 bps. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps on the month, while non-Aaa issues outperformed by 5 bps. Credit card ABS outperformed by 14 bps, while auto ABS outperformed by 7 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps in November and, at 43 bps, it is well below its average pre-crisis level. Last month we observed that after adjusting for trailing 6-month spread volatility, Aaa-rated auto loan ABS no longer offer a compelling spread pick-up relative to Aaa-rated credit card ABS. We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 9 days of average spread widening for Aaa-rated credit card ABS to underperform (Chart 9). This spread cushion is not sufficient to compensate for the fact that credit card quality metrics are in much better shape than those for auto loans. The auto loan net loss rate has entered a clear uptrend, while credit card charge-offs are still near all-time lows (bottom panel). CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in November, bringing year-to-date excess returns up to +269 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 16 bps in November, and has now fallen below its average pre-crisis level (Chart 10). Rising delinquency rates and tightening lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Further adding to our caution is that more than 6000 commercial real estate loans backing public conduit CMBS deals are set to mature in 2017. This is almost 5x the number that matured last year, according to data from Trepp. Agency CMBS outperformed the duration-equivalent Treasury index by 52 basis points in November, bringing year-to-date excess returns up to +158 bps. Agency CMBS still offer 45 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (43 bps) and greater than what is offered by conventional 30-year MBS (22 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our 3-factor Global PMI model (which includes global PMI, dollar sentiment and global policy uncertainty) places fair value for the 10-year Treasury yield at 1.82%. However, the low reading mostly reflects a large spike in global policy uncertainty in November. Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor Global PMI model (which includes only global PMI and dollar bullish sentiment) as more representative of 10-year Treasury yield fair value at the moment. The fair value reading from our 2-factor model is currently 2.26% (Chart 11). At the time of publication the 10-year Treasury yield was 2.4%. For further details on our Global PMI model please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Secular Stagnation Vs. Trumponomics", dated November 15, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, 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 Treasury Yields: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017 that will cause the Treasury curve to bear-steepen. Spread Product: Poor valuations and a probable Fed rate hike next month keep us cautious on spread product in the near term. But the environment for credit markets will turn more positive in the first half of 2017. Leveraged Loans: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Feature Several Fed speakers last week, including Fed Chair Janet Yellen, affirmed the case for a December rate hike, and the market has taken full notice of that message. We calculate that the market-implied odds of a rate hike next month rose to 84% as of the close of business on Friday.1 But just as critical for the path of Treasury yields is that the Fed will be taking a "wait and see" approach when it comes to the prospect of increased fiscal stimulus under the Donald Trump administration. Right now there is so much uncertainty about what the Congress will pass or not pass, what the president will propose. As a baseline, assuming a continuation of current fiscal policy has probably as good a chance as any other forecast that we are going to make up. Minneapolis Fed President Neel Kashkari2 This leads us to believe that the Fed will lift rates next month, but will also not revise its fed funds rate forecasts (dots) higher. We also expect that the Fed will be slow to respond to any pick-up in growth expectations as we head into 2017. This sets up a two-phase outlook for Treasury yields. During the next month, the uptrend in yields will meet resistance as both the market and Fed turn a more skeptical eye toward Trump's fiscal promises. But if growth picks up in early 2017, as we expect, and the Fed maintains its dovish bias, then we could enter a sweet spot where the Treasury curve resumes its bear-steepening and risk assets rally. Near-Term Pull-Back Two factors make us think it is likely that Treasury yields will at least level-off, and perhaps decline a bit, during the next month. First, market pricing has already mostly converged with the Fed's rate expectations, especially at the short-end of the curve (Chart 1). Our sense is that the Fed's dots provide a reasonable valuation anchor for yields in the absence of more concrete evidence that growth is accelerating. Second, technical measures and positioning data suggest that the rapid rise in yields is due for a pause. The fractal dimension for long-maturity Treasuries, a measure of groupthink developed by our Chief European Strategist Dhaval Joshi rests at 1.25, a level at which a trend reversal - even if only a temporary one - tends to emerge (Chart 2).3 Additionally, our composite sentiment indicator, based on the 13-week rate of change in prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a near-term reversal (Chart 3). Chart 1The Market & Dots Converge Chart 2Treasuries Face Technical Resistance Chart 3Bond Sentiment At A Bearish Extreme Cyclical Sweet Spot Once the December FOMC meeting has passed, we expect investor attention will turn toward U.S. economic growth, which should accelerate as we head into 2017 (Chart 4). Chart 4U.S. Growth: Poised To Accelerate Consumer confidence has been resilient at high levels, which supports continued strong consumer spending (Chart 4, panel 1). According to trends in public sector employment, government spending is poised to increase, even in the absence of new fiscal stimulus (Chart 4, panel 2). Inventories were an unusually large drag on growth in 2016. This drag will continue to unwind (Chart 4, panel 3). Survey measures suggest that non-residential investment will reverse its downtrend (Chart 4, panel 4). The supply of new residential housing remains tight, which will support increased construction even in the face of higher rates (Chart 4, bottom panel). On top of this, we can potentially tack on any newly enacted fiscal stimulus once Trump takes office in January. Our political strategists expect that the Trump administration will not face meaningful opposition from the Republican-controlled Congress, and will be able to enact - in relatively short order - a more stimulative fiscal policy in the form of lower taxes and increased spending for infrastructure and defense.4 A quicker pace of Fed tightening would be a powerful offset to this rosy growth outlook. In fact, Chair Yellen alluded to the notion that a large fiscal impulse would probably be counteracted by tighter monetary policy in her Congressional testimony last week: "The economy is operating relatively close to full employment at this point, so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state."5 In essence, with the economy close to full employment it is more likely that a sufficiently large growth impulse will result in rising inflation, which the Fed will lean against. However, we believe this is a story for the second half of 2017. At least initially, the Fed will be in no rush to deviate from the dovish bias embedded in its current forecasts. Market-based measures of inflation compensation have increased strongly in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart 5). The 5-year, 5-year forward TIPS breakeven inflation rate is currently 2.06%, and needs to rise another 34bps before it is consistent with its average pre-crisis level. The Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. This opens a window in the first half of 2017 when improving economic growth will be met with still-accommodative monetary policy. In this environment we would expect the Treasury curve to bear-steepen and spread product to outperform. All else equal, we are likely to shift our recommended portfolio allocation in that direction (initiate curve steepeners, increase allocation to spread product) once the near-term risk of a Fed rate hike is behind us. The major risk to the view that a cyclical sweet spot opens up in the first half of 2017 is that any improvement in growth might be quickly cut-off by overly restrictive financial conditions, specifically in the form of a much stronger dollar (Chart 6). The pace of dollar appreciation has increased since the election and overall indexes of financial conditions have tightened, but so far the tightening has not been as sharp as that which occurred around the time of last year's Fed rate hike. We anticipate that this time around, due to the improved trajectory of growth outside of the U.S., tightening of overall financial conditions will not be as severe. A second related risk is that the recent surge in bond yields will harm cyclical sectors of the economy such as housing and consumer spending on durable goods (Chart 7). This is undoubtedly true, but it is important to recall that this process is self-limiting. If yields rise too far, then growth will decelerate and yields will reverse course. Then lower yields will cause growth to re-accelerate, leading to higher yields. As long as the Fed is perceived to be "behind the curve" on inflation then the underlying trend will be one of improving growth and a bear-steepening of the Treasury curve. Chart 5Breakevens Still Too Low Chart 6A Strong Dollar Is The #1 Risk Chart 7Higher Yields Also A Drag On Growth Bottom Line: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017. This will cause the Treasury curve to bear-steepen and will be positive for spread product. Leveraged Loans: Still A Buy We recommended that investors favor leveraged loans over fixed-rate junk bonds on July 19.6 In large part, this recommendation was predicated on a high conviction view that Treasury yields were poised to increase, thus benefitting floating rate loans over fixed rate bonds. Since July 19, the S&P/LSTA Leveraged Loan 100 index has returned +196bps, compared to +176bps of total return from the Bloomberg Barclays High-Yield bond index, and flows into the largest leveraged loan ETF (BKLN) have outpaced flows into the largest junk bond ETF (HYG) since August (Chart 8). Historically, there are two reasons that leveraged loans might be expected to outperform fixed rate junk bonds (Chart 9). The first is that 3-month LIBOR is rising, causing loan coupons to reset higher. The second is that the default rate is elevated. Loans tend to benefit relative to bonds when the default rate is elevated because their senior position in the capital structure means they earn a higher recovery rate (Chart 10). Chart 8Loan Performance Is Lagging Fund Flows Chart 9Leveraged Loans Will Outperform Chart 10Loans Benefit From Higher Recoveries Taking a closer look at Chart 9 we can see that the above two factors have only led to two periods of sustained leveraged loan outperformance since 1991 (denoted by shaded regions). In 1994, loans outperformed bonds because the pace of Fed tightening surprised markets to the upside and 3-month LIBOR moved sharply higher. In this instance higher coupons were sufficient for loans to outperform even though corporate defaults were low. Loans also outperformed bonds between 1997 and 2002. In this case it was a prolonged uptrend in corporate defaults that drove the outperformance. Loans benefitted from higher LIBOR in the early stages of this period, but then the Fed began cutting rates in 2001. Loans did not outperform bonds during the 2004-2006 rate hike cycle, as defaults were very low and the rate hikes were well telegraphed - meaning that asset prices already reflected the up-move in 3-month LIBOR before it occurred. Likewise, loans did not outperform bonds during the 2008 default episode because the Fed was cutting rates sharply and, unlike in the 1990s, the spike and reversal in the default rate occurred over a relatively short period of time. The good news for loans is that the current environment very much resembles the early part of the 1997-2002 period insofar as the Fed is in the early stages of a rate hike cycle - so 3-month LIBOR can be expected to move higher - and corporate defaults have already started to increase. So far loans have only benefitted marginally from the rise in 3-month LIBOR because most have LIBOR floors. This means that the loan's coupon is only reset higher once 3-month LIBOR is increased above the stated floor. Bloomberg calculates that $221 billion of outstanding leveraged loans have LIBOR floors of 75bps and $690 billion of outstanding loans have LIBOR floors of 100bps. With 3-month LIBOR at 91bps currently, it will only take one more Fed rate hike before the floors on most loans are breached. Bottom Line: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: Stay Away We detailed our longer-term outlook for municipal bonds in a recent Special Report,7 and then downgraded our muni allocation to underweight (2 out of 5) following Trump's surprise election win. Our expectation is that the combination of lower tax rates and increased infrastructure spending will be toxic for municipal debt. That analysis, however, focused on investment grade municipal debt. This week we investigate the relative value in high-yield municipal bonds relative to high-yield corporates. The starting point of our analysis is an examination of the spread differential between high-yield munis and high-yield corporates (Chart 11). The second panel of Chart 11 shows that, compared to history, munis offer a sizeable spread advantage over similarly-rated corporate debt. However, this comparison does not adjust for differences in duration and convexity between the two indexes. In the bottom panel of Chart 11 we show the residual from a model where the spread differential between high-yield munis and high-yield corporates has been regressed against differences in duration and convexity. We see that high-yield munis look even more attractive after making these adjustments. These simple adjustments reveal that high-yield munis are attractive relative to high-yield corporates, but they do not consider the impact of a macro environment that is about to turn extremely negative for municipal debt. To control for this we created an augmented model of the spread differential between high-yield munis and corporates, adjusting for duration, convexity, the effective personal tax rate, relative ratings migration and several other factors (Chart 12). Chart 11High-Yield Muni Valuation I Chart 12High-Yield Muni Valuation II High-yield munis still appear quite attractive based on this model, but if we assume that the effective personal income tax rate reverts even to 2011 levels, then the a good chunk of the spread advantage vanishes (Chart 12, panel 2). This is an extremely conservative assumption. In reality, we expect the effective personal tax rate will fall much below 2011 levels under the new administration. Bottom Line: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculation differs somewhat from the widely reported probability that is available on Bloomberg terminals. The reason is that the Bloomberg calculation assumes a baseline fed funds rate of 37.5 bps (the midpoint of the Fed's current target range), while we use the current effective fed funds rate which has recently been stable at 41 bps. 2 http://www.bloomberg.com/news/articles/2016-11-16/fed-s-kashkari-says-election-hasn-t-changed-economic-outlook-yet 3 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 4 Please see BCA Special Report, "U.S. Elections: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 5 https://www.c-span.org/organization/?63944 6 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Duration: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. TIPS: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Yield Curve: An upward re-rating of the market's assessment of the equilibrium level of monetary conditions is necessary for the curve to steepen further from current levels. Spread Product: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Conversely, the sharp rise in yields turns us more cautious on MBS. Municipal Bonds: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Feature We had expected any flight to quality related to a Donald Trump victory to be brief, but would never have anticipated how brief it actually was. Treasury yields declined for about four hours as the results came in on election night, but since midnight EST last Tuesday the bond bear market has been supercharged. BCA's fixed income publications have maintained a below benchmark duration stance since July 19 with a year-end target of 1.95-2% for the 10-year Treasury yield. The 10-year yield is now above our year-end target, as Trump's surprise victory caused investors to question many long-held assumptions. Chief among them is the thesis of secular stagnation - the idea that a chronic imbalance between savings and investment has resulted in an extremely depressed equilibrium interest rate. The secular stagnation theory has ruled the day in U.S. bond markets, but even Larry Summers, who popularized the theory in recent years, has admitted that "an expansionary fiscal policy by the U.S. government can help overcome the secular stagnation problem and get growth back on track." 1 The market has been quick to take on board President Trump's promises of massive debt-financed infrastructure spending, and is now questioning the idea of permanently low interest rates. While much uncertainty about President Trump still abounds, one thing for certain is that the path of Treasury yields next year and beyond will be determined by whether Trumponomics can successfully tackle secular stagnation. As of now, we are cautious optimists. Last week BCA sent a Special Report2 to all clients that describes the likely outcomes of a Trump presidency. One of those outcomes is that a sizeable fiscal stimulus will be enacted next year. In this week's report we explore its potential impact on bond markets and re-assess our U.S. bond portfolio in light of this surprise change in the economic landscape. Duration The expected path of future rate hikes has moved sharply higher during the past week (Chart 1). If we assume that U.S. monetary conditions reach our estimate of equilibrium3 by the end of 2019, then the shaded region in Chart 1 shows a range of possible outcomes for the federal funds rate based on different scenarios for the U.S. dollar. The upper-bound of the shaded region corresponds to the path of the fed funds rate assuming the dollar depreciates by 2% per year, while the lower-bound assumes the dollar appreciates by 2% per year. The market's expected fed funds rate path has shifted into the upper-half of the shaded region, which assumes the U.S. dollar will depreciate. The thick black line corresponds to the assumption of a flat dollar. Chart 1The Market's Rate Hike Expectations: Pre- And Post-Election Since the U.S. dollar is very likely to appreciate in the event that a Trump administration enacts growth-enhancing fiscal stimulus, it would appear as though the market's expected interest rate path is already too high. However, we must consider the possibility that large-scale government investment could shift the savings/investment balance in the economy and lead to a higher equilibrium level of monetary conditions or that the U.S. economy reaches monetary equilibrium more quickly under President Trump. In that event, Treasury yields still have room to rise. Chart 2Not Much Gap Between Market & Fed Similarly, the gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart 2). The 5-year/5-year forward overnight index swap rate is now 2.05%, only about 80bps below the Fed's median estimate of the equilibrium fed funds rate. Meanwhile, our 12-month discounter - the market's expected change in the fed funds rate during the next 12 months - is already at 44bps. If there are no revisions to the Fed's interest rate forecasts at next month's meeting, then a level of 50bps on our discounter will be consistent with the Fed's expectations. This would be the first time the market and dots were lined up since 2014. The key point is that the balance of risks in the Treasury market has shifted. Prior to the election, Treasury yields had been under-estimating the potential for fiscal stimulus in 2017. Now, for Treasury yields to continue their move higher, we need to transition from a world where the Fed is continuously revising its interest rate forecasts lower to one where it is making upward revisions. To be clear, we do expect this transition to occur in 2017 but probably not during the next few months. Now that the Treasury market has reacted to the promise of fiscal stimulus, the next step is that it will demand to see some results. On that note, while Trump's infrastructure spending plan is assumed to be huge, at this point details are scarce. Further, our U.S. Investment Strategy service4 has pointed out that the effectiveness of fiscal stimulus depends critically on how well fiscal multipliers are working, and that estimates of fiscal multipliers can vary widely (Table 1). Table 1Ranges For U.S. Fiscal Multipliers Another risk to the bond bear market comes from a rapid increase in the U.S. dollar. Our modeling work shows that Treasury yields tend to rise alongside improvements in global growth (as proxied by the global manufacturing PMI), but that the impact of improving global growth on Treasury yields is dampened if bullish sentiment toward the U.S. dollar is also increasing (Chart 3). At present, the 10-year Treasury yield is very close to the fair value reading from our model, but the worry is that continued upward pressure on the dollar will cause the model's fair value to roll over in the months ahead. Another risk is the impact of a stronger dollar on emerging markets. A rebound in emerging market growth has contributed significantly to the strength in the overall global PMI since early this year (Chart 4). A strengthening dollar correlates with a weaker emerging market PMI (Chart 4, panel 2), and weakness on this front will weigh on the global growth component of our Treasury model. The possibility that President Trump will classify China as a "currency manipulator" once he takes office only exacerbates the risk from emerging markets. Chart 3Global PMI Model Chart 4EM Could Derail The Bond Bear Bottom Line: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. We therefore take this opportunity to book +35bps of profits on our tactical short December 2017 Eurodollar trade. Longer run, we expect Donald Trump will be able to deliver a sizeable fiscal stimulus package and that Treasury yields will be higher at the end of 2017. TIPS Chart 5TIPS Breakevens Still Depressed Our overweight recommendation on TIPS versus nominal Treasuries has also benefitted from Trump's win. The 10-year breakeven rate has increased +15bps since last Tuesday, but still has a long way to go before reaching levels that are consistent with the Fed hitting its inflation target (Chart 5). Trump's main economic policies - increased fiscal spending and more protectionist trade relationships - are both inflationary. The most likely candidate to derail the widening trend in breakevens would be a quicker pace of Fed rate hikes that offsets the inflationary fiscal impulse. We think a much more hawkish Fed policy is unlikely in the near term. With TIPS breakevens still so low the Fed will want to nurture their recovery toward pre-crisis levels. It is only once TIPS breakevens are much more firmly anchored at pre-crisis levels that the Fed will be enticed to significantly quicken the pace of hikes. Bottom Line: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Remain overweight TIPS versus nominal Treasuries. Yield Curve We had been positioned in Treasury curve flatteners on the view that the curve would flatten in advance of a December Fed rate hike, much as it did last year. Trump's surprise win has steepened the curve dramatically, and today we close both our curve trades taking losses of -86bps on our 2/10 flattener and -42bps on our 10/30 flattener. The best determinant of the slope of the yield curve in the long run is the deviation from equilibrium of our monetary conditions index (MCI). The curve tends to flatten as monetary conditions are being tightened toward equilibrium and steepen when monetary conditions are easing away from equilibrium. Chart 6 shows a model of the 2/10 Treasury slope versus the deviation from equilibrium of our MCI. The model works well over both pre- and post-crisis time intervals, and the trailing 52-week beta between the slope of the curve and the MCI's deviation from equilibrium is in line with the beta estimated for the entire post-1990 time interval (Chart 6, bottom panel). Chart 6The Yield Curve & Monetary Conditions The curve had appeared too flat relative to fair value prior to last week's steepening, but now appears slightly too steep (Chart 6, panel 3). Since the dollar is unlikely to depreciate substantially and the fed funds rate is unlikely to be cut, the only way that the curve can continue steepening from current levels is if the market starts to revise up its assessment of the equilibrium level of monetary conditions. This is consistent with the dynamic we observed with the level of Treasury yields. Given the rapid moves we've seen in the past week, to be confident that further curve steepening is in store we need to forecast that Trump's fiscal measures will conquer secular stagnation and that the Fed will start revising up its assessment of the equilibrium rate. Much like with the level of Treasury yields, we are reluctant to bet on further steepening in the near term, before we have seen some action on Trump's fiscal policies. However, the steepening trade has gathered enough momentum at this juncture that betting on flatteners equally does not seem wise. Bottom Line: We advocate a laddered position across the Treasury curve at the moment, while we await clarity on President Trump's fiscal proposals. The Treasury curve has room to steepen further if sizeable fiscal stimulus is implemented next year. Spread Product In recent weeks we have advocated a maximum underweight (1 out of 5) allocation to high-yield and a neutral allocation (3 out of 5) to investment grade corporates, while also avoiding the Baa credit tier. This cautious stance on corporate debt was in place for two reasons. First, the junk spread had tightened in recent months despite a slight increase in the VIX and there was a sizeable risk that a Fed rate hike in December could prompt a spike in implied volatility, with a knock-on effect on spreads. Junk spreads have since widened to be more in-line with the VIX (Chart 7), and the much steeper Treasury curve tells us that the market is now less likely to consider a Fed rate hike in December - which we still expect - a policy mistake. Consequently, we are marginally less worried about a large spike in the VIX index that would translate into wider high-yield spreads. Second, high-yield spreads were simply too low relative to our forecast for default losses in 2017 (Chart 8). A model consisting of lagged junk spreads and realized default losses explains more than 50% of the variation in excess junk returns over 12-month periods.5 Previously, this model had predicted excess junk returns of close to zero, but today's spread levels are consistent with excess junk returns of +157bps during the next 12 months. Not inspiring by any means, but still better than nothing. Given the slightly better entry level for spreads and less near-term risk of a Fed-driven volatility event, we upgrade our allocation to high-yield from maximum underweight (1 out of 5) to underweight (2 out of 5). We maintain our neutral (3 out of 5) recommendation on investment grade corporates, but remove the recommendation to avoid the Baa credit tier. The past week's large increase in Treasury yields also leads us to downgrade our allocation to MBS from overweight (4 out of 5) to underweight (2 out of 5). The low level of option-adjusted spreads makes the long-term outlook for MBS uninspiring, but we had expected that the option cost component of spreads would tighten as Treasury yields moved higher (Chart 9). Now that Treasury yields have risen sharply and the option cost has tightened, we take the opportunity to adopt a more cautious outlook on the sector. Chart 7Spreads Re-Converge With VIX Chart 8Expect Low But Positive Excess Returns Chart 9Allocate Away From MBS Bottom Line: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Now that the MBS option cost has tightened in response to higher Treasury yields, the outlook for the sector is less inspiring. Municipal Bonds A Donald Trump presidency is full-stop negative for the municipal bond market. Further, as we highlighted in a recent Special Report,6 no matter the election result the outlook for state & local government health is likely to turn more negative in the second half of next year. Trump's tax cuts de-value the tax advantage of municipal debt and will drive flows out of the sector leading to wider Municipal / Treasury (M/T) yield ratios. We had been overweight municipal bonds since August 9, anticipating that a Clinton victory might provide us with a very attractive level from which to downgrade the sector heading into 2017. It was not to be, but municipal bond yields have still not quite kept pace with the sharp increase in Treasury yields, so we are able to downgrade today with M/T ratios not far off the low-end of their post-crisis range (Chart 10). In addition to tax cuts, Trump's infrastructure plan could also be a large negative for the muni market depending on how much of it is financed at the state & local government level. While the specifics of Trump's plan are not yet known, historically, most public infrastructure spending is financed at the level of state & local government (Chart 11). Another potential risk is that if large scale tax reform is on the table in 2017, then there is always the possibility that municipal bonds will lose their tax exemption altogether. At the moment it is difficult to assign odds to such an outcome. Chart 10Municipal / Treasury ##br##Yield Ratios Chart 11State & Local Government ##br##Drives Public Investment Bottom Line: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/ 2 Please see BCA Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 3 For further details on how we estimate the equilibrium level of monetary conditions please see U.S. Bond Strategy Special Report, "Peak Policy Divergence And What It Means For Treasury Valuation", dated February 9, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, 2016, available at usis.bcaresearch.com 5 For further details on this modeling framework please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Targeting 2% The Fed did its best to avoid roiling markets so close to today's election, but still managed to hint at a December rate hike. The post-meeting statement was tweaked so that now only "some further evidence" rather than "further evidence" is required in order to lift the funds rate. We remain below benchmark duration in anticipation of a December rate hike. Before the end of the year we expect our 12-month discounter to reach at least 40-50bps (meaning the market will expect a further 1-2 hikes in 2017) from its current level of 28bps, and for the 10-year Treasury yield to reach 1.95-2%. While our global PMI model pegs fair value for the 10-year Treasury yield at 2.27%, the uptrend in the 10-year yield will face severe technical resistance as it approaches 2% (Chart 1). Positioning has already moved to net short duration, signaling that the bond sell-off is becoming stretched. While a Clinton victory would all but ensure a December rate hike, a Trump victory could cause a large enough market riot that the Fed delays until 2017. This would only be a brief hiccup in the return of the 10-year yield to the 1.95-2% range, and would not signal a long-lasting trend reversal. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by +56bps in October, but have already given back -26bps of those gains so far this month (Chart 2). The index option-adjusted spread is -2bps tighter than at the end of September and, at 136bps, it remains very close to its historical average. Corporate credit performance faces two immediate risks. The first is today's election and the second is the prospect of a Fed rate hike in December. A Clinton victory would likely prompt a knee-jerk rally in risk assets and virtually ensure a rate hike next month. In that case we would be inclined to further trim exposure to credit risk in the coming weeks as the rate hike approaches. Already, we recommend investors avoid the Baa credit tier within a neutral allocation to investment grade corporates. In a recent report we pointed out that highly-rated credit (A-rated and above) performed well in the initial stages of last year's run-up in rate hike expectations, but then started to suffer once market-implied rate hike probabilities approached 100%.1 Conversely, a Trump victory would likely prompt a flight-to-safety event in markets which, depending on its severity, could also cause the Fed to delay the next rate hike into 2017. In that event, the prospect of delayed Fed tightening would make us more likely to increase credit exposure in the near term, especially if any knee-jerk sell-off in risk assets creates better value in corporates. Table 3Corporate Sector Relative Valuation And Recommended Allocation* (Continued) Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by +92bps in October, but has already underperformed the Treasury benchmark by -108bps so far in November. The index option-adjusted spread is +25bps wider since the end of September and, at 505bps, it is 16bps below its historical average. In a Special Report2 published last week we noted that while the default rate will not re-visit its previous lows (at least until after the next recession), it should decline from 5.4% to close to 4% during the next 12 months (Chart 3). However, even a slightly brighter default outlook will not be enough for junk bonds to sustain their current pace of outperformance. A simple model of lagged junk spreads and default losses explains more than 50% of the variation in 12-month high-yield excess returns. This model suggests that even with lower default losses, excess junk returns will be +264bps during the next 12 months (panel 3). The reason is that lower default losses are more than offset by the lower starting point for spreads. Junk spreads should also come under widening pressure in the very near term, as a December Fed rate hike spurs an increase in implied volatility. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +2bps in October, but are underperforming the benchmark by -7bps so far in November. Year-to-date, MBS have outperformed the duration-equivalent Treasury index by a mere +22bps. Since the end of September, the conventional 30-year MBS yield has risen +23bps, driven by a +21bps increase in the rate component. The option-adjusted spread has widened +2bps, while the compensation for prepayment risk (option cost) has remained flat. Unattractive option-adjusted spreads and the prospect of further increases in issuance make for bleak long-run return prospects in MBS. However, the likelihood that Treasury yields will continue to rise in the near-term means that MBS could outperform due to a decline in the option cost component of spreads (Chart 4). We will likely reduce exposure to MBS once a December rate hike has been fully digested by the market, and the uptrend in Treasury yields starts to taper off. The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to ease standards on GSE-eligible mortgage loans, while demand for these same loans continues to increase. The combination of easing lending standards and strengthening demand means that issuance is likely to continue its march higher, as does the persistent uptrend in existing home sales (bottom panel). Government Related: Overweight Chart 5Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by +5bps in October, but has already underperformed the Treasury benchmark by -9bps so far in November. The Foreign Agency and Local Authority sub-sectors drove October's outperformance, returning +24bps and +14bps in excess of Treasuries respectively. Domestic Agency debt outperformed the Treasury benchmark by +3bps, while Supranationals (-7bps) and Sovereigns (-10bps) both underperformed. After adjusting for differences in credit rating and duration, Foreign Agency and Local Authority bonds still appear attractive relative to investment grade U.S. corporate debt. Sovereigns, on the other hand, appear modestly expensive. We continue to recommend avoiding Sovereign issues while remaining overweight the other sub-sectors of the government related index. In a recent report,3 we observed that the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the U.S. dollar. As such, a continued bull market in the U.S. dollar will remain a significant headwind for sovereigns. At the country level, the only nations whose USD-denominated debt offers a spread advantage over Baa-rated U.S. corporate debt are Hungary, South Africa, Colombia and Uruguay. Unusually, bullet agency debt outperformed callable agency debt last month even though Treasury yields moved higher (Chart 5). Within Domestic Agency bonds, we continue to favor callable over bullet issues on the expectation that this divergence will not persist. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by -12bps in October, dragging year-to-date excess returns down to -152bps (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio is largely unchanged since the end of September, and remains close to its post-crisis average. In recent months, trends in M/T yield ratios have fluctuated alongside the betting market odds for today's Presidential election. A Trump victory would cause yield ratios to widen sharply, as President Trump's promised tax cuts would substantially de-value the tax advantage in municipal bonds. We expect yield ratios to tighten in the event that Clinton prevails, as any expectation of a Trump victory works its way out of the price. Due to attractive yield ratios relative to recent history, we are inclined to remain overweight municipal bonds in the near-term. However, we will likely downgrade the sector if yield ratios move back to previous lows. As we detailed in a recent Special Report,4 historical lags between the corporate and municipal credit cycles suggest that municipal bond downgrades will start to increase in the second half of next year, alongside a deterioration in state & local government balance sheets. Further, state & local government investment spending is poised to move higher next year, regardless of the election result, leading to even greater muni issuance (Chart 6). Elevated fund flows have offset the impact of strong issuance this year, the risk is that they will not keep pace going forward. Treasury Curve: Stay In Flatteners Chart 7Treasury Yield Curve Overview The Treasury curve has bear-steepened significantly since the end of September. The 2/10 Treasury slope has steepened +16bps and the 5/30 slope has steepened +14bps. As a result, our two curve flattener trades have struggled. Our 2/10 Treasury curve flattener has returned -41bps since initiation on September 6. Our 10/30 Treasury curve flattener has returned -25bps since initiation on September 20. Our other tactical trade - short December 2017 Eurodollar - has returned +16bps since initiation on July 12. All three of the above tactical trades are premised on the view that the Fed will deliver a rate hike in December, and that such a rate hike has not yet been fully discounted by the market. At present, we calculate that the market-implied probability of a December rate hike is 62%, as discounted in fed funds futures. The historical pattern suggests the yield curve should bear flatten as the rate hike probability approaches 100%. Unusually, the correlations between both the 2/10 and 10/30 Treasury slopes and the level of Treasury yields have moved into positive (bear-steepening) territory (Chart 7). This is especially unusual for the 10/30 slope, where the correlation has been firmly in negative (bear-flattening) territory since 2013. We continue to recommend holding curve flatteners, and expect both correlations to revert into negative (bear-flattening) territory in advance of a December rate hike, as they did last year. Any surge in bullish dollar sentiment between now and December would only increase the flattening pressure on the curve (bottom panel). So far bullish dollar sentiment has remained relatively flat, but we cannot discount a large increase in the run-up to the next rate hike, as occurred last year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by +112bps in October. The 10-year breakeven rate has increased +8bps since the end of September, and currently sits at 1.68%. The 10-year TIPS breakeven rate has increased substantially during the past couple months, and has now converged with the fair value reading from our TIPS Financial model (Chart 8). Rising expectations of a Fed rate hike and a flatter Treasury curve will weigh on TIPS during the next month, and we would not be surprised to see breakevens temporarily cease their uptrend as attention turns to Fed hawkishness following today's election. But we also expect that TIPS breakevens will resume their uptrend heading into next year. As we flagged in a recent report,5 the sensitivity of TIPS breakevens to core inflation has increased since the financial crisis. We posit that the reason for this increased sensitivity is that the Fed's ability to control long-dated inflation expectations has been impaired by the zero-lower bound on rates. As a result, the trend in breakevens is increasingly taking its cue from the realized inflation data. Realized inflation continues to trend steadily higher (bottom two panels), and diffusion indexes suggest that further gains are ahead (panel 4). Given that breakevens remain well below pre-crisis levels, we intend to remain overweight TIPS relative to nominal Treasuries and ride out any near-term volatility related to a Fed rate hike. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by +10bps in October, bringing year-to-date excess returns up to +101bps. Aaa-rated ABS outperformed the Treasury benchmark by +8bps on the month, while non-Aaa issues outperformed by +24bps. The index option-adjusted spread for Aaa-rated ABS has tightened -3bps since the end of September and, at 45bps, is considerably below its pre-crisis average (Chart 9). According to our days-to-breakeven measure, there still exists a valuation advantage in Aaa-rated auto ABS relative to Aaa-rated credit card ABS, but that advantage is rapidly evaporating (panel 3). We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 10 days of average spread widening for Aaa-rated credit card ABS to underperform. Moreover, credit card ABS exhibit superior collateral credit quality relative to autos. Credit card charge-offs remain near all-time lows, while the auto net loss rate appears to have bottomed (bottom panel). Further, the Fed's senior loan officer survey shows that auto lending standards have tightened for two consecutive quarters, while credit card lending standards were unchanged in Q3 following 25 consecutive quarters of net easing (panel 4). We recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans within a maximum overweight allocation to consumer ABS. CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date outperformance up to +194bps. The index option-adjusted spread for non-agency Aaa-rated CMBS has tightened -3bps since the end of September, and remains very close to its pre-crisis average (Chart 10). The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to tighten standards on all classes of commercial real estate (CRE) loans (panel 3). The survey also shows that CRE loan demand continues to increase, though at a less rapid pace than in prior quarters. While CRE prices continue to march higher (bottom panel), tightening lending standards and a rising delinquency rate (panel 4) make us cautious on non-agency CMBS. Agency CMBS outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date excess returns up to +105bps. Agency CMBS still offer 56bps of option-adjusted spread. This is greater than what is offered by Aaa-rated consumer ABS (45bps) and conventional 30-year MBS (19bps) for a similar amount of spread volatility. We continue to recommend overweight positions in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our Global PMI Treasury model places fair value for the 10-year Treasury yield at 2.27% (Chart 11). This model is based on a linear regression of the 10-year Treasury yield on three factors, using a post-financial crisis time interval.6 The three factors are: Global Growth: Measured using the Global Manufacturing PMI (sourced from JP Morgan and Markit) Global Growth Divergences: Proxied by bullish sentiment toward the U.S. dollar (sourced from Marketvane.net) Economic Uncertainty: Measured using the Global Economic Policy Uncertainty Index (sourced from policyuncertainty.com) The correlation between the global PMI and the 10-year Treasury yield is strongly positive (panel 3). However, improving global growth is offset by any increase in bullish sentiment toward the U.S. dollar. For a given level of global growth any increase in bullish sentiment toward the dollar represents a drag on interest rate expectations. As such, bullish dollar sentiment enters our model with a negative sign (panel 4). The final component of our model - global economic policy uncertainty - captures changes in Treasury yields related to headline risk and "flights to quality". This factor enters our model with a negative sign - more uncertainty correlates with lower bond yields (bottom panel). Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 6 For additional details on the model please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, 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 Muni Credit Cycle: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. Issuance: State & local government investment spending will increase in 2017, as will muni issuance for new capital. Pensions: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. Election: Muni/Treasury yield ratios have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Feature The financial crisis marked a major inflection point in the municipal bond market. Not only did the economic fall-out from the housing crash lead to historically large state & local government budget gaps, but the end of bond insurance and a growing realization that municipal default is possible have focused investor attention on credit quality more than ever before. In this Special Report we zero-in on the Municipal/Treasury (M/T) yield ratio.1 We identify its major short-run and long-run drivers, and assess where it is headed in the context of the municipal bond credit cycle. The Longer-Run Outlook For Yield Ratios An important input to our understanding of the municipal credit cycle is our Muni Health Monitor (MHM). The MHM is a composite of eight indicators of state & local government budget health. Full details of the indicator and its components can be found in the Appendix to this report. The MHM has an excellent track record of signaling the major inflection points in muni ratings migration (Chart 1). We observe that the MHM bottomed in 2006, one year before the previous trough in ratings migration. The MHM also crossed into "deteriorating health" territory six months before municipal downgrades started to outpace upgrades in 2008. More recently, the MHM crossed back into "improving health" territory in Q4 2012. Muni ratings migration also peaked in Q4 2012 and upgrades began outpacing downgrades in Q4 2014. Chart 1The Municipal Health Monitor Leads Ratings We pay attention to the trends in muni ratings because ratings and state & local government net borrowing explain more than 50% of the variation in the average M/T yield ratio since 1997 (Chart 2). Further, increased investor focus on the creditworthiness of municipal issues has made the yield ratio even more responsive to ratings and net borrowing since the Great Recession. So where are we currently situated in the muni credit cycle? The MHM remains in "improving health" territory, but appears to have entered an extended bottoming-out phase. Given the re-leveraging that has already occurred in the corporate sector, it would be extremely unusual for the MHM to improve further during this cycle. In fact, our Corporate Health Monitor tends to lead the MHM by about two years (Chart 3). This squares with what we know about the behavior of state & local governments throughout the economic cycle. Chart 2The Muni Credit Cycle Illustrated I Chart 3The Muni Credit Cycle Illustrated II Typically, the corporate sector will increase debt loads when times are good and will then be forced to de-lever when the economy enters recession, profits contract and those debt loads become unsustainable. State & local government budget gaps, on the other hand, will tend to narrow during an economic recovery as rapid income growth translates into increased tax revenue. It is only during a recession that state & local government budget gaps widen, since tax revenue plummets while expenditure growth - particularly for social benefits - remains firm. The end result is that the municipal credit cycle tends to lag the corporate credit cycle. This is also apparent in the ratings data (Chart 3, bottom panel), which suggest that we should expect to see muni downgrades (and hence yield ratios) head higher near the end of next year. The typical lag between the corporate credit cycle and the municipal credit cycle suggests that M/T yield ratios should remain well behaved until late-2017, and then begin to move higher. However, the extraordinary length of the current economic recovery gives us some cause to believe that the lags in this cycle may be somewhat longer. We turn to a macro analysis of net state & local government borrowing to shed some further light on this issue. Net borrowing is simply the difference between revenues and expenditures. On the revenue side of the ledger, state & local governments have already seen a significant deceleration in tax receipts during the past year (Chart 4). Every source of tax revenue - except for property taxes - has slowed alongside what has been disappointing overall economic growth so far in 2016. While a return to the 10% revenue growth that was seen in the mid-2000s is unlikely, we expect most of the recent deceleration will soon be reversed. Aggregate weekly hours bounced sharply in September (Chart 5), and federal income tax withholdings also continue to grow rapidly. Both indicators suggest that income growth will be stronger during the next few months, which will support state & local tax receipts. On the expenditures side, while spending on social benefit programs has increased, state & local governments have largely dealt with budget gaps by cutting back severely on discretionary spending (Chart 6). Investment spending has also collapsed and, as a result, gross municipal bond issuance has been dominated by refinancing (Chart 6, bottom two panels). Chart 4S&L Government Revenue Chart 5Income Growth Will Rebound Chart 6S&L Government Expenditures This could all be about to change. Both U.S. Presidential candidates have prioritized infrastructure spending as part of their platforms. Hillary Clinton plans to increase infrastructure spending by $500 billion. This consists of $250 billion of federal infrastructure spending over the next five years and $25 billion of seed money to create a national infrastructure bank. The bank would also accept an additional $225 billion in direct loans. Clinton's plan would also bring back the Build America Bonds (BABs) program. Donald Trump has also expressed a desire to invest heavily in infrastructure, and has floated figures in the range of $1 trillion, although he has been less specific about the details. Historically, about 70% of public investment has occurred at the state & local government level (Chart 7). This suggests that if infrastructure spending became a priority it would lead to a large increase in state & local government investment and hence municipal bond issuance. However, with Clinton's plan it is still unclear whether the bulk of infrastructure spending would be financed through the Treasury market or the muni market. Certainly, to the extent that increased spending is financed through the BABs program, then tax-exempt muni issuance would not be impacted. In our view, state & local government investment spending will head higher in 2017 even without any support from the new President. The need for state & local governments to invest in infrastructure has been evident for some time, but only recently have budgets become healthy enough for governments to consider it. There is a strong correlation between state & local government investment spending and the net percentage of states with a total balance (general fund plus rainy day fund) that exceeds 5% of expenditures (Chart 8). This figure has just recently moved into positive territory and, not coincidentally, more than $200 billion worth of infrastructure spending will be on ballots requesting voter approval in November.2 Chart 7State & Local Government ##br##Drives Investment Chart 8Healthy Enough##br## To Invest The combination of resilient, but not surging, revenue growth and increased investment spending in 2017 is consistent with the idea that the muni credit cycle will follow the lead of the corporate cycle and start to turn near the end of next year. Bottom Line: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. The Pension Problem Of course, the elephant in the room with regards to the long-run outlook for municipal credit quality is pensions. So far pensions have only entered our discussion of the muni credit cycle tangentially, since the pension funded ratio is a component of the MHM (see Appendix). However, large unfunded pension liabilities - should they persist - have the potential to be severely destabilizing for the muni market at some point in the future. According to the U.S. National Accounts, aggregate defined benefit pension entitlements at the state & local government level total $5.6 trillion, only 65% of which are currently funded by assets. However, this aggregate figure masks large divergences between a few municipalities with unsustainable pension liabilities and the majority of municipalities where pension liabilities are probably manageable. Chart 9Low Returns Put Pressure On Pensions In a recent report,3 the Center for Retirement Research at Boston College found that 36 states should be able to fund their existing liabilities by making annual payments that total less than 15% of revenue. However, five states - Illinois, New Jersey, Connecticut, Hawaii and Kentucky - require annual payments in excess of 25% of revenue. The breakdown is found to be similar at the city level, where pension costs were found to be manageable for the majority of cities, although Chicago, Detroit, San Jose, Miami, Houston, Baltimore, Wichita and Portland all face annual pension costs that exceed 40% of revenue. Unfortunately, while the pension situations of most municipalities are currently manageable, they are only likely to get worse. Changes in the aggregate pension funded ratio closely track returns from a portfolio that is 50% invested in the S&P 500 and 50% invested in the Barclays Treasury index (Chart 9). Based on current equity valuations, it is probably only reasonable to expect 6% annual nominal returns from the equity market during the next 10 years,4 and the 10-year Treasury yield suggests that 1.8% is a reasonable expectation for annual nominal Treasury returns. Taken together, annual nominal investment returns from a 50/50 portfolio during the next decade could be close to 4%, far below the historical average of 8.9% and also below the 7.6% average return assumed by state & local pension plans in 2014. The two main points are that: The pension problem is likely to get worse, not better Given that large under-funded pensions are concentrated in only a few states, inter-state muni allocations are very important On this second point, we observe that states with lower pension funded ratios have higher General Obligation (GO) bond yields (Chart 10), and also that not all of the difference is reflected in credit ratings. We ran a cross-sectional regression of GO bond yields against credit rating and found that a correlation remains between the residual from that regression and the pension funded ratio (Chart 11). In other words, credit rating does not adequately control for the risk presented by under-funded pensions. Chart 10Municipal Bond Yields Vs. Pension Funded Ratios Chart 11Municipal Bond Yields Vs. Pension Funded Ratios: Controlling For Credit Rating Bottom Line: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. The Short-Run Outlook For Yield Ratios So far we have discussed the muni credit cycle and noted that M/T yield ratios should begin to move higher on a sustained basis at some point near the end of 2017. However, the near-term drivers of M/T yield ratios suggest that an overweight allocation to municipal bonds remains appropriate for the time being. We have found that the bulk of near-term volatility in M/T ratios can be explained by four factors (Chart 12): The Global Policy Uncertainty Index5 Gross municipal bond issuance Net municipal mutual fund flows Ratings migration The Brexit shock to policy uncertainty has now mostly been reversed. Meanwhile, our Muni Excess Supply Indicator (Chart 12, panel 4) shows that gross issuance has been outpacing fund inflows of late. This should put upward pressure on yield ratios, although this pressure has been largely offset by still supportive ratings migration (Chart 12, bottom panel). Considering all factors, this short-term model shows that the average M/T yield ratio is close to fair value. A reading close to fair value is consistent with muni returns that should exceed those from duration-equivalent Treasuries most of the time (Table 1), even before adjusting for the muni tax advantage. In fact, Table 1 shows that the odds of muni underperformance only really increase once the M/T ratio appears more than one half standard deviation expensive on our model. Chart 12A Short-Term Muni Model Table 1Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 The other near-term factor that supports a continued overweight allocation to municipal debt is the prospect of a Clinton victory in next month's election. Since the beginning of the year, the average M/T ratio has closely tracked the probability of a Trump election victory (Chart 13). The reasoning is entirely logical. Trump has promised large tax cuts for the highest earners. Such tax cuts would significantly de-value the tax advantage of municipal bonds and pressure yield ratios higher. In contrast, Clinton promises to raise taxes on high income individuals. This would make the tax advantage of municipal debt more valuable, and pressure yield ratios lower. Chart 13Trump Is Bad For Yield Ratios The average M/T yield ratio has not yet discounted Trump's recent plunge in the polls. This argues for the maintenance of an overweight allocation to municipal debt in the near term. Bottom Line: M/T yield ratios appear fairly valued in the near-term, and have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Appendix: The BCA Municipal Health Monitor The BCA Municipal Health Monitor is an equal-weighted composite of eight indicators meant to quantify trends in state & local government budget gaps and debt service capability. The components consist entirely of data that are publicly available from the Bureau of Economic Analysis, Federal Reserve, Bureau of Labor Statistics and the National Association of State Budget Officers. The eight components are described below, and shown graphically in Charts A1 & A2. Chart A1Muni Health Monitor Components I Chart A2Muni Health Monitor Components II Leverage: The ratio of total state & local government liabilities (excluding unfunded pension liabilities) to total financial assets. Interest Coverage: State & local government current budget surplus (excluding interest expenditures) divided by interest expenditures. The current surplus is calculated as the difference between current revenues and current expenditures (i.e. investment spending is excluded). Pension Funded Ratio: Total assets of state & local government pension funds divided by total pension liabilities. Revenue: State & local government current revenue in nominal terms, as a deviation from its 18-quarter trend. Surplus Margin: State & local government current budget surplus as a % of current revenue. Liquidity: State & local government total financial assets less short-term liabilities, as a % of total financial assets. Employment Growth: Year-over-year % change in state and local government employment. Total Balance: Aggregate state government total year-end balance. The total balance is the general fund balance plus the rainy day fund, as a % of total expenditures. 1 The average M/T yield ratio shown in this report is calculated by taking an equal-weighted average of M/T yield ratios for 2-year, 5-year, 10-year and 30-year maturities. For each maturity point the yield ratio is calculated as the ratio between the Bloomberg Fair Value Aaa Municipal bond yield and the Federal Reserve's constant maturity Treasury yield. 2 http://www.bloomberg.com/news/articles/2016-09-13/mega-deals-lead-ballo… 3 http://crr.bc.edu/briefs/will-pensions-and-opebs-break-state-and-local-… 4 Please see Global Investment Strategy Special Report, "Global Equity Valuations: Risks And Opportunities", dated July 1, 2016, available at gis.bcaresearch.com 5 The index was created by Professors Scott Baker, Nick Bloom and Steven Davis and is driven by the number of times terms related to economic and policy uncertainty are found in newspaper articles. Full details of the methodology are available at www.policyuncertainty.com

There are two key risks that could derail a bear-flattening of the yield curve. The first is a Trump election victory, the second is a flaring of stress in the non-U.S. banking sector.

It's hard to make a case for attractive returns from any asset class over the next year. We dial down risk a bit but ending our overweight on junk bonds. Investors should pick up yield where they can but without taking excessive risk.

With recent comments strongly hinting that the Fed is on track for a rate hike in December, the dy-namics of the Fed Policy Loop make spread product appear extremely vulnerable.

Eventually the easing of financial conditions will strengthen the Fed's resolve to lift rates. Rate hike probabilities will rise and risk assets will struggle to cope with higher Treasury yields.