Real Estate

Highlights The Federal Reserve’s monetary policy stance is slightly accommodative for the U.S., but it is too tight for the rest of the world. Inflation is likely to slow further before making a durable bottom toward year-end. The Fed will remain on an extended pause, maybe all the way through to December 2020. The trade war is not going away, and investors should not be complacent. However, it also guarantees that Chinese policymakers will redouble on their reflationary efforts. As a result, global growth is still set to improve in the second half of 2019. The dollar rally is in its last innings; the greenback will depreciate in the second half of this year. Treasury yields have limited downside and their recent breakdown is likely to be a fake-out. Use any strength in bond prices to further curtail portfolio duration. The correction in stocks is not over. However, the cycle’s highs still lie ahead. Feature Ongoing Sino-U.S. tensions and weakness in global growth are taking their toll. The S&P 500 has broken below its crucial 2,800 level, EM equities are quickly approaching their fourth-quarter 2018 lows, U.S. bond yields have fallen to their lowest readings since 2017, copper has erased all of its 2019 gains and the dollar is attempting to break out. In response, futures markets are now pricing in interest rate cuts by the Fed of 54 bps and 64 bps, over the next 12 and 24 months, respectively. Will the Fed ratify these expectations? Last week’s release of the most recent Fed’s Federal Open Market Committee meeting minutes, as well as comments from FOMC members ranging from Jerome Powell to Richard Clarida, are all adamantly clear: U.S. monetary policy is appropriate, and a rate cut is not on the table for now. However, the avowed data-dependency of the Fed implies that if economic conditions warrant, the FOMC will capitulate and cut rates. Even as U.S. inflation slows, a recession is unlikely. Moreover, the Sino-U.S. trade war will catalyze additional reflationary policy from China, putting a floor under global growth. In this context, the Fed is likely to stay put for an extended period, but will not cut rates. While the S&P 500 is likely to fall toward 2,600, the high for the cycle is still ahead. We therefore maintain our positive cyclical equity view, especially relative to government bonds, but we are hedging tactical risk. Fed Policy Is Neutral For The U.S…. If the fed funds rate was above the neutral rate – the so-called R-star – we would be more inclined to agree with interest rate markets and bet on a lower fed funds rate this year. However, it is not clear that this is the case. Chart I-1Mixed Message From The R-Star Indicator Admittedly, the inversion of the 10-year/3-month yield curve is worrisome, but other key variables are not validating this message. Currently, our R-star indicator, based on M1, bank liquidity, consumer credit, and the BCA Fed monitor, is only in neutral territory (Chart I-1). Moreover, we built a model based on the behavior of the dollar, yield curve, S&P homebuilding relative to the broad market and initial UI claims that gauges the probability that the fed funds rate is above R-star. Currently, the model gives a roughly 40% chance that U.S. monetary policy is tight (Chart I-2). Historically, such a reading was consistent with a neutral policy stance.   Chart I-2Today, Fed Policy Is At Neutral Models can be deceiving, so it is important to ensure that facts on the ground match their insights. Historically, housing is the sector most sensitive to monetary policy.1 Key forward-looking activity measures are not showing signs of stress: mortgage applications for purchases have jumped to new cyclical highs, and the NAHB homebuilders confidence index has smartly rebounded after weakening last year (Chart I-3). Also, homebuilder stocks have been in a steady uptrend relative to the S&P 500 since last October (Chart I-3, bottom panel). These three developments are not consistent with tight monetary policy. Chart I-3This Would Not Happen If Policy Were Tight The corporate sector confirms the message from the housing sector. While capex intentions have weakened, they remain at elevated levels, despite slowing profit growth and elevated global uncertainty. Moreover, the latest Fed Senior Loan Officer Survey shows that banks have again eased credit standards for commercial and industrial loans. Netting out all these factors, we are inclined to agree with the Fed that monetary policy in the U.S. is broadly neutral. If anything, the rebound in leading indicators of residential activity would argue that policy is even slightly accommodative. … But Not For The Rest Of The World Congress gave the Fed a U.S.-only mandate, but the U.S. dollar is the global reserve currency. Because the dollar is the keystone of the global financial architecture, between US$12 trillion and US$14 trillion of foreign-currency debt is issued in USDs, and the greenback is used as a medium of exchange in roughly US$800 trillion worth of transaction per year.2 Therefore, the Fed may target U.S. monetary conditions, but it sets the cost of money for the entire world. While U.S. monetary conditions may be appropriate for the U.S., they are not entirely appropriate for the world as a whole. Indeed, the green shoots of growth we highlighted two months ago are rapidly turning brown: Korean and Taiwanese exports, which are highly sensitive to the global and Asian business cycles, are still contracting at a brisk pace (Chart I-4, top panel). Japan, an economy whose variance in GDP mostly reflects global gyrations, is weakening. Exports are contracting at a 4.3% yearly pace, machine tool orders are plunging at a 33% annual rate and the coincident indicator is below 100 – a sign of shrinking activity. The semiconductor space is plunging (Chart I-4, second panel). Our EM Asia diffusion index, which tallies 23 variables, is near record lows (Chart I-4, third panel). Europe too is feeling the pain, led by Germany, another economy deeply dependent on global activity. The flash estimate for the euro area manufacturing PMI fell to 47.7 and plunged to 44.3 in Germany, its lowest level since July 2012 (Chart I-4, bottom panel). These developments show that the world economy remains weak, in part because the Chinese economy has yet to meaningfully regain any traction. The rebound in Chinese PMI in March proved short lived; in April, both the NBS and Caixin measures fell back to near the 50 boom/bust line. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor. A strong dollar is a natural consequence of an outperforming U.S. economy, especially when global growth weakens. Thus, the rally in the Fed’s nominal trade-weighted dollar to its highest level since March 2002 is unsurprising (Chart I-5). A strong Greenback will have implications for inflation, and thus the Fed. Chart I-4Global Growth: No Green Shoots Here Chart I-5A Strong Dollar Is A Natural Consequence Of Weak Growth   Transitory Inflation Weakness Is Not Over The Fed believes the current inflation slowdown is transitory. We agree. With a tight labor market and rising wages, the question is not if inflation will rise, but when. In the current context, it could take some time. As Chart I-6 shows, inflation has been stable for more than 20 years. From 1996 to today, core PCE has oscillated between 0.9% and 2.6%, while core CPI has hovered between 0.6% and 2.9%, with the peaks and troughs determined by the ebbs and flows of global growth. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor, likely around 1.3% and 1.5% for core PCE and core CPI, respectively. Chart I-6Stable U.S. Inflation Since 1996 A few dynamics strengthen this judgment: The strength in the dollar is deflationary (Chart I-7, top panel). Not only does an appreciating greenback depress import prices, it tightens U.S. and global financial conditions. It also undermines dollar-based liquidity, especially if EM central banks try to fight weakness in their own currencies. All these forces harm growth, commodity prices and ultimately, inflation. Chart I-7More Downside Ahead In Inflation For Now After adjusting for their disparate variance, the performance of EM stocks relative to EM bonds is an excellent leading indicator of global core inflation (Chart I-7, second panel). This ratio is impacted by EM financial conditions, explaining its forecasting power for prices. Since goods inflation – which disproportionally contributes to overall variations in core CPI – is globally determined, U.S. inflation will suffer as well. U.S. capacity utilization is declining (Chart I-7, third panel). The U.S. just underwent a mini inventory cycle. The 12-month moving averages of the Philadelphia Fed and Empire State surveys’ inventory indexes still stand above their long-term averages. U.S. firms will likely use discounts to entice customers, especially as a strong dollar and weak global growth point to limited foreign outlets for this excess capacity. Finally, the growth in U.S. unit labor costs is slowing sharply, which normally leads inflation lower (Chart I-7, bottom panel). Average hourly earnings may now be growing at a 3.2% annual pace, but productivity rebounded to a 2.4% year-on-year rate in the first quarter, damping the impact of higher salaries on costs. If global growth is weak and U.S. inflation decelerates further, the Fed is unlikely to raise interest rates anytime soon. As the Fed policy remains modestly accommodative and the labor market is at full employment, the balance of probability favors an extended pause over a cut. But keep in mind, next year’s elections may mean this pause could last all the way to December 2020. How Does The Trade War Fit In? An additional irritant has been added to the mix: the growing trade tensions between the U.S. and China. The trade war has resurrected fears of a repeat of the 1930 Smoot-Hawley tariffs, which prompted a wave of retaliatory actions, worsening the massive economic contraction of the Great Depression. There is indeed plenty to worry about. Today, global trade represents 25% of global GDP, compared to 12% in the late 1920s. Global growth would be highly vulnerable to a freeze in world trade. Besides, global supply chains are extremely integrated, with intra-company exports having grown from 7% of global GDP to 16% between 1993 and 2013. If a full-blown trade war were to flare up, much of the capital invested abroad by large multinationals might become uneconomic. As markets price in this probability, stock prices would be dragged down. Chart I-8Trade Uncertainty Alone Will Delay The Recovery The fear of a full-fledged trade war is already affecting the global economy. The fall in asset prices to reflect the risk of stranded capital is tightening financial conditions and hurting growth. Moreover, the rise in U.S. and global economic uncertainty is depressing capex intentions (Chart I-8). Since capex intentions are a leading variable for actual capex, global exports and manufacturing activity, the trade war is deepening and lengthening the current soft patch. Markets need to be wary of pricing in a quick end to the Sino-U.S. trade conflict. Table I-1 presents BCA’s Geopolitical Strategist Matt Gertken’s odds of various outcomes to the trade negotiations and their implications for stocks. Matt assigns only a 5% probability to a grand compromise between the U.S. and China on trade and tech. He also foresees a 35% chance that a deal on trade excluding an agreement on tech will be reached this year. This leaves 10% odds that the two sides agree to extend the negotiation deadline beyond June, 20% odds of no deal at all and a minor escalation, and 30% odds of a major escalation. In other words, BCA is currently assigning 60% odds of a market-unfriendly outcome, and only a 40% chance of a genuinely market-friendly one.3 Why the gloom? The U.S. and China are geopolitical rivals in a deadlock. Moreover, both parties are feeling increasingly emboldened to play hardball. On the U.S. side, President Donald Trump has threatened to expand his tariffs to all of China’s exports to the U.S., which would represent a major escalation in both the conflict and its cost (Chart I-9). However, despite the scale of the threat, even if it were fully borne by U.S. households, its impact should be kept in perspective. Imports of consumer goods from China only represent 2% of total household spending (Chart I-10, top panel). Moreover, households are not currently overly concerned with inflation, as goods prices are already muted (Chart I-10, middle panel) and family income is still growing (Chart I-10, bottom panel). Finally, a weak deal could easily be decried as a failure in the 2020 election. On the Chinese side, the 9.5% fall in the yuan is already absorbing some of the costs of the tariffs, and the RMB will depreciate further if the trade war escalates. Additionally, Chinese exports to the U.S. represent 3.4% of GDP, while household and capital spending equals 81% of output. China can support its domestic economy via fiscal and credit policy, greatly mitigating the blow from the trade war. The outlook for Chinese reflationary efforts is therefore paramount. In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. Not only do Chinese policymakers have the room to stimulate, they also have the will. In the first four months of 2019, Chinese total social financing flows have amounted to CNY 9.6 trillion, which compares favorably to the same period during the 2016 reflation campaign. Yet, the economy has not fully responded to the injection of credit and previously implemented tax cuts amounting to CNY 1.3 trillion or 1.4% of GDP. Consequently, GDP per capita is now lagging well behind the required path to hit the government’s 2020 development targets (Chart I-11). Moreover, Chinese policymakers’ recent comments have increasingly emphasized protecting employment. This combination raises the likelihood of additional stimulus in the months ahead. Chart I-10...But Do Not Overstate Trump's Constraints Chart I-11Chinese Stimulus: Scope And Willingness   Therein lies the paradox of the trade war. While its immediate effect on world growth is negative, it also increases the chance that Chinese authorities pull all the levers to support domestic growth. A greater reflationary push would thus address the strongest headwind shaking the global economy. It could take two to six more months before the Chinese economy fully responds and lifts global growth. Ultimately, it will. Hence, even as the trade war continues, we remain skeptical that the Fed will cut interest rates as the market is discounting. We are therefore sticking to our call that the Fed will not cut rates over the next 12 months and will instead stay on an extended pause. Investment Conclusions The Dollar So long as global growth remains soft, the dollar is likely to rally further. That being said, the pace of the decline in global growth is decelerating. As a corollary, the fastest pace of appreciation for the greenback is behind us (see Chart I-5 on page 6). The risk to this view is that the previous strength in the dollar has already unleashed a vicious cycle whereby global financial conditions have tightened enough to cause another precipitous fall in world growth. The dollar’s strong sensitivity to momentum would then kick in, fomenting additional dollar strength in response to the greater growth slowdown. In this environment, the Fed would have no choice but to cut interest rates. However, growing reflationary efforts around the world currently confine this scenario to being a risk, not a central case. Additional factors also limit how far the dollar can rally. Speculators have already aggressively bought the greenback (Chart I-12). The implication is that buyers have moved in to take advantage of the dollar-friendly fundamentals. When looking at the euro, which can be thought of as the anti-dollar, investors are imputing a large discount in euro area stocks relative to U.S. ones, pointing to elevated pessimism on non-U.S. growth (Chart I-13). It would therefore require a much graver outcome in global growth to cause investors to further downgrade the outlook for the rest of the world relative to the U.S. and bring in new buyers of greenbacks. Chart I-12USD: Supportive Fundamentals Are Already Reflected Chart I-13Plenty Of Pessimism In European Assets...   In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. The same factors that are currently putting the brakes on the dollar’s rise will fuel its eventual downturn. As global growth bounces, a liquidation of stale long-dollar bets will ensue. European growth will also rebound (Chart I-14), and euro pessimism will turn into positive surprises. European assets will be bought, and the euro will rise, deepening the dollar’s demise. We are closely following the Chinese and global manufacturing PMIs to gauge when global growth exits its funk. At this point, it will be time to sell the USD. Government Bonds Bonds are caught between strong crosscurrents. On the one hand, rising economic uncertainty caused by the trade war, slowing global economic activity and decelerating inflation are all bond-bullish. On the other hand, bond prices already reflect these tailwinds. The OIS curve is baking in 54 basis points of Fed cuts over the next 12 months, as well as a further 10 basis points over the following 12 months (Chart I-15, top panel). Meanwhile, term premia across many major bond markets are very negative (Chart I-15, middle panel). Finally, fixed-income investors have pushed their portfolio duration to extremely high levels relative to their benchmark (Chart I-15, bottom panel). Chart I-14...Creates Scope For Positive Surprises Chart I-15Fade The Treasury Rally   Last week, Treasury yields broke down below 2.34%. For this technical break to trigger a new down-leg in yields, investors must curtail their already-depressed expectations of the fed funds rate in 12-months’ time. However, the fed funds rate is not yet restrictive, and global growth should soon find a floor in response to expanding Chinese stimulus. Under these circumstances, the Fed is unlikely to cut rates, and will continue to telegraph its intentions not to do so. Hence, unless the S&P 500 or the ISM manufacturing fall below 2,500 and 50, respectively, any move lower in yields is likely to be transitory and shallow. Cyclically, yields should instead move higher. Our Global Fixed Income Strategy service’s duration indicator has already turned the corner (Chart I-16). Moreover, in the post-war period, Treasury yields have, on average, bottomed a year before inflation. Expecting an inflation trough in late 2019 or even early 2020 is therefore consistent with higher yields by year-end. Finally, when the Fed does not cut interest rates as much as the markets had been anticipating 12-months’ prior, Treasurys underperform cash. This is exactly BCA’s current Fed forecast. Chart I-16Global Yields Now Have More Upside Than Downside While we expect the bond-bearish forces to emerge victorious, yields may only rise slowly. The list of aforementioned supports for Treasury prices is long, the equity market will remain volatile and has yet to trough, and the trade war is likely to linger. We continue to closely monitor the AUD, the SEK versus the EUR, and copper to gauge if our view is wrong. These three markets are tightly linked to Chinese growth. If China’s stimulus is working, these three variables will rebound, and our bond view will be validated. If these three variables fall much further, U.S. yields could experience significantly more downside. Equities Equities are at a difficult juncture. The trade war is a bigger problem for Wall Street than for Main Street, as 43.6% sales of the S&P 500’s are sourced abroad. Moreover, the main mechanism through which trade tensions impact the stock market is through the threat that capital will be stranded – and thus worthless. This is a direct hit to the S&P 500, especially as global growth has yet to clearly stabilize and the Chinese are only beginning to make clearer retaliatory threats. Oil could also hurt stocks. Energy prices have proven resilient, despite weaker global economic activity. OPEC and Russia have been laser-focused on curtailing global crude inventories; even after the U.S. declined to extend waivers on Iranian exports, the swing oil producers have not meaningfully increased supply. Problems in Venezuela, Libya, and potential Iranian adventurism in Iraq could easily send oil prices sharply higher, especially as the U.S. does not have the export capacity to fulfill foreign demand. Thus, the oil market could suddenly tighten and create a large drag on global growth. This backdrop also warrants remaining overweight the energy sector. Stocks remain technically vulnerable. Global and U.S. stock market breadth has deteriorated significantly, as shown by the number of countries and stocks above their 200-day moving averages (Chart I-17). Moreover, since March, the strength in the S&P 500 has been very narrow, as shown by the very poor performance of the Value Line Geometric Average Index (Chart I-18). Meanwhile, the poor relative performance of small-cap stocks in an environment where the dollar is strong, where U.S. growth is holding steady compared to the rest of the world and where multinationals have the most to lose from a trade war, is perplexing. Chart I-17Stocks Remain Technically Fragile Chart I-18Dangerous Internal Dynamics   The U.S. stock market has the most downside potential in the weeks ahead. Like last summer, U.S. equity prices remain near record highs while EM and European stocks, many commodities and bond yields have been very weak. Moreover, the broad tech sector, the U.S.’s largest overweight, has defied gravity, despite weakness in the semiconductor sector, the entire industry’s large exposure to foreign markets, and the consequential slowdown in our U.S. Equity Strategy service's EPS model (Chart I-19).4 Thus, any bad news on the trade front or any additional strength in the dollar could prove especially painful for tech. This would handicap U.S. equities more than their already beaten-up foreign counterparts. Chart I-19The Tech Sector Profit Outlook Remains Poor These forces mean that the global equity correction will last longer, and that U.S. equities could suffer more than other DM markets. However, we do not see the S&P falling much beyond the 2,700 to 2,600 zone. Again, the fed funds rate is slightly accommodative and a U.S. recession – a prerequisite for a bear market (Chart I-20) – is unlikely over the coming 12 months. Moreover, global growth should soon recover, especially if China’s reflationary push gathers force. Additionally, an end to the dollar’s rally would create another welcomed relief valve for stocks. Chart I-20The Absence Of A Recession Means This Is A Correction, Not A Bear Market In this context, we recommend investors keep a cyclical overweight stance on stocks. Balanced portfolios should also overweight stocks relative to government bonds. However, the near-term risks highlighted above remain significant. Consequently, we also recommend investors hedge tactical equity risks, a position implemented by BCA’s Global Investment Strategy service three weeks ago.5 As a corollary, if stocks correct sharply, the associated rise in implied volatility will also cause a violent but short-lived pick up in credit spreads. In Section II, we look beyond the short-term gyrations. One of BCA’s long-term views is that inflation is slowly embarking on a structural uptrend. An environment of rising long-term inflation is unfamiliar to the vast majority of investors. In this piece, Juan-Manuel Correa, of our Global Asset Allocation team, shows which assets offer the best inflation protection under various states of rising consumer and producer prices. Mathieu Savary Vice President The Bank Credit Analyst May 30, 2019 Next Report: June 27, 2019 II. Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. U.S. Treasuries U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. U.S. REITs While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Commodity Futures Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. U.S. Inflation-Protected Bonds While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Sub-Asset Classes Global Equity Sectors For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel).   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation   III. Indicators And Reference Charts Last month, we argued that the S&P 500 would most likely enter a period of digestion after its furious gains from December to April. This corrective episode is now upon us as the S&P 500 is breaking below the crucial 2,800 level. Moreover, our short-term technical indicators are deteriorating, as the number of stocks above their 30-week and 10-week moving averages have rolled over after hitting elevated levels, but have yet to hit levels consistent with a durable trough. This vulnerability is especially worrisome in a context where pressure will continue to build, as Beijing is only beginning to retaliate to the U.S.’s trade belligerence. Our Revealed Preference Indicator (RPI) is not flashing a buy signal either. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. It will require either cheaper valuations, a pick-up in global growth or further policy easing before stocks can resume their ascent. On the plus side, our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Hence, stock weaknesses are likely to prompt buy-the-dip behaviors by investors. Therefore, the expected downdraft will remain a correction and stocks have more cyclical upside. Our Monetary Indicator remains in stimulative territory, supporting our cyclical constructive equity view. The Fed is firmly on hold and global central banks have been opening the monetary spigots, thus monetary conditions should stay supportive. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message of our Monetary Indicator, especially as our Composite Technical Indicator has moved back above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are slightly expensive. Moreover, our technical indicator flags a similar picture. However, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Taking this positioning into account, BCA’s economic view is consistent with limited yield downside in the short-run, and higher yields on a 6 to 12 month basis. On a PPP basis, the U.S. dollar is only getting ever more expensive. Additionally, our Composite Technical Indicator is not only in overbought territory, it is also starting to diverge from prices. Normally, this technical action points to a possible trend reversal, especially when valuations are so demanding. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes   Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Edward E. Leamer, "Housing is the business cycle," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 149-233, 2007. 2       This includes both real and financial transactions. 3       Please see Geopolitical Strategy Weekly Report, “How Trump Became A War President,” dated May 17, 2019, available at gps.bcaresearch.com 4       Please see Global Investment Strategy Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 5       Please see U.S. Equity Strategy Weekly Report, “Trader's Paradise,” dated January 28, 2019, available at uses.bcaresearch.com 6       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 7       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 8       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 9       Excess returns are defined as asset return relative to a 3-month Treasury bill. 10       Sector classification does not take into account GICS changes prior to December 2018.  11       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 12       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 13       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights Currency markets continue to fight a tug of war between weak incoming data but easier financial conditions. Our thesis remains that the path of least resistance for the dollar is down, but the rising specter of global market volatility suggests it could catapult to new highs before ultimately reversing. Most of our pro-cyclical trades have been put offside in this environment of rising volatility. Maintain tight stops until more evidence emerges that global growth has bottomed.  Large net short positioning in the Swiss franc and yen, together with cheap valuations, make them attractive from a contrarian standpoint. Hold on to CHF/NZD positions recommended on April 26. Feature Our thesis remains that global growth is in a volatile bottoming process. However, incoming data pretty much across the globe has been very weak, with the latest specter of a global trade war suggesting that economic softness could linger for longer than we originally anticipated.  Given the shifting market dynamics, it is important to revisit our thesis on how to be positioned in currency markets. We do so this week via the lens of the Australian dollar, one of the market’s favorite short positions. Future reports will focus on additional global growth barometers, and when to time the shift towards a more pro-cyclical stance. Positive Divergences Chart I-1Global Growth Barometers Flashing Amber On the surface, most data points appear negative for the Aussie dollar. Typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices are breaking down after a nascent upturn earlier this year. One of our favorite indicators on whether or not easing liquidity conditions will lead to higher growth are the CRB Raw Industrials index-to-gold, copper-to-gold, and oil-to-gold ratios. It is disconcerting that these indicators have moved decidedly lower together with U.S. bond yields, another global growth barometer (Chart I-1). On a similar note, currencies in emerging Asia that sit closer to the epicenter of Chinese stimulus are breaking down. This suggests that so far, policy stimulus in China has not been sufficient to lift global growth, and/or the transmission mechanism towards higher growth is not working.   Not surprisingly, the Australian dollar has been breaking down at a rapid pace, putting our long AUD/USD position offside. We will respect our stop-loss at 0.68 if breached, but a few indicators suggest the bearish view on the Australian dollar is very late: Chart I-2Australian Stocks Hitting New Highs Election Results: The recent general election outcome was a big surprise to the market, and has eased risks to both the country’s banks and housing market. The center-left Labour party, which moved further to the left in this electoral cycle, was defeated by a substantial margin. This has a few important implications. First, “negative gearing” – the practice of using investment properties that are generating losses to offset one’s income tax bill – will remain in place. This was a big overhang on the housing market, which likely exacerbated the downturn in Aussie house prices. Second, the capital gains tax exemption from selling properties will probably not be reduced from 50% to 25%, as previously pledged. Finally, the Liberal-National coalition government will maintain the policy of reimbursing investors for corporate taxes paid by the underlying company. This keeps the incentive for retirees to own high dividend-yielding equities such as those of Australian banks. Australian equities hit a new cyclical high following the election results. This suggests the return on capital for Aussie companies may have inched higher following the more pro-market leadership shift (Chart I-2). At low levels of interest rates, fiscal policy is much more potent than monetary policy. Interest Rates: The latest Reserve Bank Of Australia (RBA) minutes suggest that rate cuts are back on the agenda. But the question is, with the markets pricing in two rate cuts by the end of this year, does it still pay to be short the Aussie dollar on widening interest rate differentials? More importantly, fiscal policy is set to become decisively loose this year. The new government is slated to introduce income tax cuts as early as July. This is skewed towards lower-income households, meaning the fiscal multiplier may be larger than what the Australian economy is normally accustomed to. Meanwhile, infrastructure spending will remain high, which will be very stimulative for growth in the short term. At low levels of interest rates, fiscal policy is much more potent than monetary policy, and the RBA will be loath to cut rates more than is currently expected by the market, at a time when consumer indebtedness remains quite high, and policy rates are already close to rock-bottom levels. The key for the RBA will be the job market, which at the moment remains a pillar of support for the Aussie economy. Job growth is accelerating, and labor force participation is hitting fresh  highs (Chart I-3). So long as these trends continue, the RBA can afford to remain on the sidelines for a while longer. Meanwhile, while Aussie rates continue to drift downward, it has not been particularly profitable to buy U.S. Treasurys on a hedged basis (Chart I-4). Chart I-3Australia Employment Remains Robust Chart I-4It is Expensive To Short The Aussie Housing Market: For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities has rapidly morphed into a housing crash (Chart I-5). This is negative for consumption, both via the wealth effect and as well as for the outlook for residential construction activity. Chart I-5Could Australian Housing Bottom Soon? The good news is that policy is supposed to become supportive for Aussie homebuyers at the margin, with the government slated to introduce new initiatives to help first-time homebuyers. Should labor market improvements continue, it will also help household income levels. Over the past few decades, house prices in Australia have generally staged V-shaped recoveries when at this level of contraction. Betting on at least some stabilization going forward seems reasonable. Commodity Prices: One bright spot for the Aussie dollar has been rising terms of trade. Admittedly, most measures of Chinese (and global) growth remain weak. However, there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. If these advance any further, they will begin to exceed GDP growth, indicating a renewed mini-cycle (Chart I-6). Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. In recent months, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role. Meanwhile, Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-7). Given that the reduction – if not the outright elimination – of pollution is a long-term strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost. Chart I-6Some Green Shoots From China Chart I-7Australian LNG Will Buffet Terms Of Trade Valuation: In terms of currency performance, a lot of the bad news already appears priced in to the Australian dollar, which is down 15% from its 2018 peak, and 38% from its 2011 peak. Meanwhile, Australian dollar short positions appeared to have already hit a nadir. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-8). One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 10% (Chart I-9). Chart I-8Short AUD: ##br##A Consensus Trade Chart I-9AUD Is Attractive From A Terms Of Trade Perspective   China Credit Cycle: We have discussed at length how a revival in the Chinese credit cycle will help global and Australian growth. On the real estate front, residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signaling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales have usually been in sync across city tiers. A revival in the property market will support construction activity and investment. Chart I-10How Long Will The Weakness In China Last? House prices have been rising to the tune of 10%-15% year-on-year, and may be sniffing an eventual pick-up in property volumes. Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufacturers cutting retail prices. This should help retail sales (Chart I-10). Other Global Growth Barometers Investors looking for more clarity on the global growth picture from the April and May data prints remain in a quandary. And the preliminary European PMI numbers this morning offered no glimmers of hope. That said, the most volatile components of euro area growth tend to be investment and net exports. Should they both pick up on the back of stronger external demand, GDP could easily gravitate towards 1.5%-2%, pinning it well above potential. The German PMI is currently among the weakest in the euro zone. But forward-looking indicators suggest we may be on the cusp of a V-shaped bottom over the next month or so (Chart I-11). Chart I-11German Manufacturing Might Be At The Cusp Of A V-Shaped Recovery The broad message is that global growth is in the midst of volatile bottoming process. However, before evidence of this fully unfolds, markets are likely to be swayed by the ebbs and flows of higher-frequency data. We recommend maintaining a pro-cyclical bias at the margin, but having tight stop losses as well as positions in both the Swiss franc and yen as insurance. Housekeeping Our buy-limit order on the British pound was triggered at 1.30 on March 29th. As we argued at the time, the pound was sitting exactly where it was after the 2016 referendum results, but the odds of a hard Brexit had significantly fallen. Since then, policy-induced volatility has led to a significant depreciation in the pound, with our position at risk of being stopped out at our 1.25 stop-loss this week. Given the rising specter of political volatility, we will respect our stop-loss if breached at 1.25. On the domestic front, economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The reality is that the pound and U.K. gilt yields should be much higher – solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape (Chart I-12). The CPI data this week confirm that the domestic environment is hardly deflationary. That said, given the rising specter of political volatility, we will respect our stop-loss if breached at 1.25. Chart I-12Hold GBP/USD, But Stand Aside At 1.25   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been soft: The Michigan consumer sentiment index jumped to 102.4 in May. However, the Chicago Fed national activity index fell to -0.45 in April. The Redbook index increased by 5.4% year-on-year in May. Existing home sales contracted by 0.4% month-on-month to 5.2 million in April. Moreover, new home sales fell by 6.9% month-on-month in April. The Markit composite index fell to 50.9 in April. The manufacturing and services PMI fell to 50.6 and 50.9 respectively. Importantly, this a just a nudge above the 50 boom/bust level. DXY index initially increased by 0.3%, then plunged on the weak PMI data, returning flat this week. The FOMC minutes released on Wednesday reiterated that the recent drop in core inflation is mostly transitory, and that no strong evidence exists for a rate change in either direction. With the forward market already pricing an 82% probability of a rate cut this year, any hawkish shift by the Fed will be a surprise. However, this will not necessarily be bullish for the dollar, if accompanied by a global growth bottom. We remain of the view that the path of least resistance for the dollar is down. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline consumer price inflation was unchanged at 1.7% year-on-year in April, while core inflation increased to 1.3%. The current account balance narrowed to a surplus of 24.7 billion euros in March. However, this was above expectations. German GDP was unchanged at 0.6% year-on-year in Q1. The euro area Markit composite PMI was flat at 51.6 compared to the last reading of 51.5. Below the surface, both the manufacturing and services PMIs fell to 47.7 and 52.5, respectively. German composite PMI was held up at 52.4 by the services component that came in at 55. However, the manufacturing component fell to 44.3. German IFO current assessment dropped to 100.6 in May, and the business climate dropped to 97.9. In France, the Markit composite PMI came in at 51.3. The manufacturing and services PMIs both increased, to 50.6 and 51.7 respectively. This was the one bright spot in euro area data. EUR/USD has been flat this week, with recent data being on the softer side. The PMI data remain subdued, in particular. Meanwhile, political uncertainties continue to weigh on investors’ sentiment. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Q1 annualized GDP grew by 2.1% quarter-on-quarter, well above estimates. Industrial production fell by 4.3% year-on-year in March, but was higher than the previous reading of -4.6% in February. Capacity utilization fell by 0.4% month-on-month in March. Exports contracted by 2.4% year-on-year in April, while imports increased by 6.4% year-on-year. The total trade balance thus narrowed from ¥528 billion to ¥64 billion. Notably, the exports to China fell by 6.3%, while exports to the U.S. increased by 9.6%. Machinery orders fell by 0.7% year-on-year in March. Nikkei manufacturing PMI fell below 50, coming in at 49.6 in May. USD/JPY fell by 0.5% this week. Yutaka Harada, a dovish member of the BoJ, warned during a news conference that by hiking the consumption tax rate at this critical juncture, Japan could risk sliding into a recession. With core CPI far from its 2% target, more monetary easing is probably exactly what the doctor ordered. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been firm: The Rightmove house price index increased by 0.1% year-on-year in May. The orders component of the CBI industrial trends survey decreased to -10 in May. Retail sales increased by 3% year-on-year in April. Producer prices and input prices increased by 2.1% and 3.8%, year-on-year respectively in April. Headline inflation and core inflation increased by 2.1% and 1.8% year-on-year in April, both below expectations. GBP/USD decreased by 0.6% this week. Teresa May offered MPs a vote on a second referendum on Brexit, which considers a tighter customs union with the EU. The ongoing Brexit chaos has increased volatility in the pound. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 117.2 this week. Westpac leading index fell by 0.1% month-on-month in April. Completed construction work fell by 1.9% in Q1. AUD/USD fell by 0.3% this week. During this week’s federal election, the coalition government led by Prime Minister Scott Morrison won. Besides the political development, the RBA governor Philip Lowe gave a speech on Monday, highlighting external shocks to Australian economy. He also expressed the positive outlook for Australian economy in the second half of 2019 and 2020, supported by the ongoing capex in infrastructure and resources sectors, together with strong population growth. More importantly, he mentioned that the RBA would consider the case for lower interest rates, which is a dovish shift from previous speeches. We are long AUD/USD with a tight stop at 0.68. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Credit card spending growth missed expectations, coming in at 4.5% year-on-year in April. Retail sales increased by 0.7% quarter-on-quarter in Q1. Retail sales excluding autos increased by 0.7% quarter-on-quarter in Q1. NZD/USD fell by 0.3% this week. NZD/USD is currently trading at a 7-month low around 0.65. A bleak external picture is worrisome for the kiwi. We continue to favor the AUD/NZD cross, from a strategic standpoint. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been solid: Retail sales increased by 1.1% month-on-month in March. In particular, retail sales excluding autos increased by 1.7% month-on-month, well above estimates.  USD/CAD appreciated by 0.3% this week. The better-than-expected retail sales data in March sparked a small rally in the loonie. However, the rally proved to be short-lived following softer oil prices. Positive data surprises in Canada will have to be sustained for the loonie to find some measure of support. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in the Switzerland have been positive: Money supply (M3) growth was unchanged at 3.5% year-on-year in April. Industrial production increased by 4.3% year-on-year in Q1, albeit lower than the last reading of 5.1%.  USD/CHF fell by 0.8% this week. As we argued in last week’s research note, the increasing global market volatility has reignited interest in the Swiss franc. We continue to recommend the franc as an insurance policy amid rising geopolitical risk. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was little data out of Norway this week: The unemployment rate came in at 3.5% in March, well below consensus of 3.7% and the previous reading of 3.8%. USD/NOK fell by 0.4% this week. Rising geopolitical risks will be supportive of the oil market and put a floor under the krone. Aside from the U.S.-Iran tensions, the world faces the prospect of the loss of Venezuelan production, and significant outages in Libya, which are all bullish. Meanwhile, Norway remains one of few G10 countries that can hike interest rates in the near term. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Capacity utilization increased by 0.5% in Q1. Moreover, the unemployment rate fell to 6.2% in April. This was well below expectations of 6.8% and the previous month’s reading of 7.1%. USD/SEK fell by 0.3% this week. While we favor both the NOK and SEK against the U.S. dollar, near-term factors are more bullish for the krone. Our long NOK/SEK position is currently 4.38% in the money. Stick with it. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

HighlightsU.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade.How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge.We find that the level of inflation is very important in determining which assets work best.When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS.When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio.However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further.FeatureSome 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today.But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following:A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart I-1A, top panel).Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart I-1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity.Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart I-1A, bottom panel).Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart I-1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available.Demographics: The population in the U.S. is set to age in coming years (Chart I-1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart I-1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. Chart I-1AStructural Forces Point To Higher Inflation In The Coming Decade (I)  Chart I-1BStructural Forces Point To Higher Inflation In The Coming Decade (II) If our view is correct, how should investors allocate their money?We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment.In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4 BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only.We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments.Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart I-2 and Table I-1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them.Summary Of ResultsTable I-2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below.Which assets perform best when inflation is rising?Rising inflation affects assets very differently, and is especially dependent on how high inflation is.Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation.Commodities and U.S. TIPS were the best performers when inflation was high or very high.U.S. REITs were not a good inflation hedge.Which global equity sectors perform best when inflation is rising?Energy and materials outperformed when inflation was high.Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses.Which commodities perform best when inflation is rising?With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles.Industrial metals outperformed when inflation was high.Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility.What is the cost of inflation hedging?To answer this question, we construct four portfolios with different levels of inflation hedging:Benchmark (no inflation hedging): 60% equities / 40% bonds.Low Inflation Hedging: 50% equities / 40% bonds / 5% TIPS / 5% commoditiesMedium Inflation Hedging: 40% equities / 30% bonds / 15% TIPS / 15 % commoditiesPure Inflation Hedging: 50% TIPS / 50% commodities. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Chart I-3Inflation Hedging Comes At A Cost While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart I-3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart I-3, panel 3).What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart I-3, panel 4).Investment ImplicationsHigh inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following:1.  At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation.2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now.3.  Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate.4.  When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio.5.  When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio.Asset ClassesGlobal EquitiesThe relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-1, top panel).This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations:Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-1, bottom panel).When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation.When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations.With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile.U.S. TreasuriesU.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices.The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs.U.S. REITsWhile REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles.Commodity FuturesCommodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return:Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-4, bottom panel).When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return.Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive.U.S. Inflation-Protected BondsWhile inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation.Sub-Asset ClassesGlobal Equity SectorsFor the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data.Once again, we separate rising inflation periods into four quartiles, arriving at the following results:When inflation was low, information technology had the best excess returns while utilities had the worst (Chart III-1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple.When inflation was mild, energy had the best performance, followed by information technology (Chart III-1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods.When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart III-1, panel 3).When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart III-1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. EquitiesHow do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities?The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart III-2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar.When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart III-2, panel 2). The dollar was roughly flat in this environmentU.S. stocks started to have negative excess returns when inflation was high (Chart III-2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period.U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart III-2, panel 4). The dollar was roughly flat in this period. Individual CommoditiesOur analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8Total return for every commodity was lower than spot return when inflation was low (Chart III-3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns.When inflation was mild, energy had the best performance of any commodity by far (Chart III-3, panel 2). Precious and industrial metals had low but positive excess returns in this period.When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart III-3, panel 3).We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart III-3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns  64% of the time compared to 52% for silver.Other AssetsU.S. Direct Real Estate Chart IV-1Direct Real Estate Is A Good Inflation Hedge Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform?We analyzed direct real estate separately from all other assets because of a couple of issues:Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies.The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate.Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation.Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart IV-1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart IV-1, bottom panel). Cash Chart IV-2Very High Inflation Erodes The Value Of Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample. (Chart IV-2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart IV-2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa OssaSenior Analystjuanc@bcaresearch.com Footnotes1      Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004).2      Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, available at gis.bcaresearch.com and Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com.3      We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004.4      Excess returns are defined as asset return relative to a 3-month Treasury bill.5      Sector classification does not take into account GICS changes prior to December 2018. 6      Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com.7      It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations.8      We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile.       

Highlights Odds are that the recently improved access to financing will allow property developers to boost construction volumes modestly in the coming months. Yet, the outlook for new credit origination and government tolerance of another credit binge is highly uncertain. For now, the completion of previously launched projects will help construction-adjacent industries in the short run. However, these activities will consume real estate developers’ cash augmenting both their liquidity needs and financial vulnerability. That is a basis to underweight the Chinese real estate sectors within both the Chinese MSCI investable universe and the onshore A-share indexes. Feature The emergent divergence among Chinese property sales, starts and completions constitutes an exceptionally bizarre phenomenon. The gaps between these three indicators are currently unprecedented (Chart I-1). Understanding these divergences is critical to correctly gauging the outlook for the Chinese real estate market. This report aims to assess the growth outlook of these three variables. Odds are that these gaps will narrow going forward. Over the next three to six months, the Chinese property market is likely to be characterized by a contraction in floor space sold, a considerable relapse in floor space starts, and a rebound in floor space completions (Chart I-2). Chart I-1An Unprecedented Divergence… Chart I-2…But A Convergence Looms   In terms of the strength of construction activity in the Chinese property market, the real estate developers’ access to funding has been and remains the key. Over the next three to six months, the Chinese property market is likely to be characterized by a contraction in floor space sold, a considerable relapse in floor space starts, and a rebound in floor space completions. For now, we reckon the improved access to financing in recent months should help property developers to boost construction volumes modestly in the coming months (Chart I-3). Chart I-3Construction Activity Will Modestly Improve In The Coming Few Months That said, the current round of credit stimulus has probably been front-loaded in the first quarter, and property developers’ access to funding will begin to deteriorate again going forward. This will weigh on their ability to raise construction volumes materially. Understanding The Construction Cycle In China Floor space sold, starts and completions generally move in tandem. Specifically, strong sales lead rising starts, which then with a time lag result in increased completions. However, over the past 15 months, the growth rate of property starts has accelerated to over 20%, while sales have mildly contracted and floor space completions have been shrinking dramatically (Chart I-2). The key reason for these divergences has been the considerable financing difficulties facing property developers. Tighter monetary policy and credit beginning in late 2016 severely impaired developers’ ability to raise funds. This made Chinese real estate developers desperate for any source of possible revenue or financing. Launching new projects aggressively last year – i.e., more property starts – allowed real estate developers to pre-sell and get cash at a time when credit was tight.  Property developers were also aiming to conserve cash flow amid tight credit. After investing 25% of the total investment required for a property project (excluding the value of the land), they received a presale permit from the authorities. The permits allowed them to sell housing units in advance. Home-buyers had to pay at least 30% of the total property value at the time they signed the presale contract. This way, developers were able to obtain both deposits and advance payments1 (Chart I-4). This was a welcome addition to scarce financing last year. After this phase, property developers then slowed their investment in construction, installation and equipment purchases – because these would consume precious, limited cash. This depressed construction activity has resulted in a material contraction in floor space completed (Chart I-5). Chart I-4Developers’ Funding Has Improved Due To Deposits & Advanced Payments   Bottom Line: Launching new projects and pre-selling housing units while shrinking construction enabled Chinese real estate developers to stay afloat last year amid tight access to credit. What Does This Mean? There are two important implications related to this unprecedented divergence among property sales, starts and completions. The first is that raising funds via launching property starts along with shrinking completions has resulted in a significant increase in Chinese property developers’ liabilities. This is a form of borrowing money for property developers, and it has been occurring on top of very poor financial health. Specifically, Chinese real estate developers’ debt-to-equity ratio is currently above 4, and continues to surge (Chart I-6). Further, in 2018, 54 out of 131 Chinese property developers had negative free cash flow. This scheme of raising funding via new launches along with postponing building and completions is becoming unsustainable. The divergence between surging property starts and contracting completions suggests that real estate developers have raised funds through selling more uncompleted buildings instead of completed properties (Chart I-7, top panel). Chart I-6Chinese Property Developers Are Very Leveraged Chart I-7A Big Increase In Sales Of Uncompleted Buildings   Specifically, some 87% of total residential floor space sold in the past 12 months has been sold in advance, much higher than the approximate 77% total recorded in the years prior to 2018 (Chart I-7, bottom panel). The second important implication is that property developers’ ability to raise financing will determine the strength of property construction activities in China going forward. Chinese real estate developers are facing massive funding requirements this year. Developers need considerable amounts of funding this year to speed up their construction activities on delayed projects (launched but not completed ones). It generally takes about two years for real estate developers to complete a construction project and deliver the presold properties. Developers had already slowed their construction progress last year. They must accelerate the pace this year to ensure deliveries are made on time. Developers also need to roll over or repay significant amounts of debt coming due in 2019. On the whole, they have issued nearly RMB3.9 trillion of bonds so far, with most in the three- to five-year duration. Chart I-3 on page 2 shows that further improvements in credit flows in the economy will likely lead to ameliorating construction activity. Credit easing has allowed developers to raise funds through bank loans, bond issuances (both domestic and overseas) and other forms of borrowing (Chart I-8). Property developers’ ability to raise financing will determine the strength of property construction activities in China going forward. As a result, real estate investment in construction, installation and equipment purchases have all ameliorated in recent months (Chart I-9). This reflects a true pickup in real estate construction activities since the beginning of this year. Chart I-8Marginal Credit ##br##Easing   However, whether or not this latest improvement develops into full-fledged recovery is contingent on credit flows in the economy in general, and property developers’ access to financing in particular. If the overflow of credit decelerates after the massive binge that took place in the first quarter, it will weigh on construction activity. If the first-quarter credit binge persists, Chinese property developers will likely be able to raise sufficient funds to speed up property completions and roll over their maturing debt this year. In this scenario, construction activity will gather speed, facilitating a recovery in the overall economy.  At the current juncture, it is impossible to make a definite conclusion. The outlook for new credit flows and government tolerance of another credit binge is highly uncertain. On the one hand, the Politburo last month reiterated that China will push forward structural deleveraging and prevent speculation in the property market. Preliminary credit flow numbers for April appear to be very weak, not confirming blockbuster credit in the first quarter. Besides, the banking regulator has renewed pressure on banks to recognize non-performing loans and provision for them.2 This will curb banks’ ability to originate new loans and buy corporate bonds. On the other hand, an escalation of tensions between China and the U.S. and the uncertainty it is instilling in the economy and financial markets could lead the authorities to keep the credit taps open for longer, allowing credit to flow into the broader economy. Bottom Line: Real estate developers are extremely leveraged and lack cash to complete launched projects. Hence, property developers’ ability to raise financing holds the key in terms of the strength of property construction activities in China. Further easing in credit will likely lead to rebounding property completions and rising construction activity, and vice versa. What About Chinese Property Demand? Easy credit may alleviate the financing stress facing Chinese real estate developers and lift construction activity temporarily. However, the most important and sustainable source of funding for real estate developers is property sales. Chart I-10 shows that funding from property sales, including deposits, advance payments and mortgages assumed by property buyers, contributes nearly half of the sources of funds raised in that year. Self-raised funds are the second-largest component of the source of funds, with a share of 34%. One major component of self-raised funds – retained earnings – are also closely related to property sales. The other major component is equity and bond issuance. Bank loans and foreign investment (including direct equity injections, sales of bonds and equity, and borrowing from foreign banks) together account for only about 15%. Even though there has been some credit easing for Chinese real estate developers, the bad news is that property sales are still in a structural downtrend. Chart I-11Slower PSL Injections Will Negatively Impact Property Demand As discussed in our previous reports,3 China’s property market is currently facing structural impediments. Low affordability, slowing rural-to-urban migration, demographic changes, the promotion of the housing rental market and the government’s continuing emphasis on clamping down speculation are together generating strong structural headwinds for property demand in China. Importantly, surging property demand between late 2015 and 2017 was mainly driven by the Chinese central bank’s direct lending to the real estate sector, which is not sustainable. Our calculations indicate that about 20% of floor space sold (in volume terms) in 2017 was due to the Pledged Summary Lending (PSL) facility designed for slum area reconstruction.4 Indeed, the central bank’s PSL injections have already decelerated considerably since last year (Chart I-11). This has resulted in contracting overall property sales. Late last month, the authorities significantly cut their slum-area reconstruction target by more than one-half – from 6.4 million units last year to 2.85 million units this year. This suggests the amount of PSL injections will decline correspondingly (Chart I-12). Besides the diminishing PSL scheme, some other factors are also signaling a dismal outlook for Chinese property demand. A deep and long contraction in property demand in rich provinces indicates demand saturation (Chart I-13). Sales outside eastern provinces track PSL injections very closely, as per Chart I-11, and are facing headwinds. Chinese households are more leveraged than U.S. ones, with the former’s debt-to-disposable income ratio having surpassed that of the latter (Chart I-14). Chart I-13Demand Is Saturated In China’s (Richer) Eastern Provinces Chart I-14China’s Household Debt Burden Is Very Elevated   In addition, mortgage rates in China have not dropped much, despite monetary policy easing in the past 12 months. Recent data shows the average mortgage rate paid by first-time homebuyers has fallen from 5.71% last November to 5.56% this March, a still-high number. With respect to the ability to service mortgage payments, on a 90-square-meter house with a 30% down payment, our calculations show that annual interest costs account for about 27% of average household disposable income levels (Table I-1). Overall, poor affordability for Chinese homebuyers will constrain property demand in the coming years. Finally, the government is quite determined to implement its property tax in a few years. Local governments’ financing needs will become more acute as revenue from land sales decline substantially. China’s property market is on the way to becoming the market dominated by second-hand properties instead of new buildings – similar to many developed countries. Critically, the progress in establishing property tax laws in China seems to be accelerating. There have been more high-level meetings and discussions about the property tax law, and these meetings/discussions are becoming more detailed and concrete. Bottom Line: Chinese housing demand will be in a structural downtrend, weighing on construction activity beyond any near-term rebound. Investment Implications Based on the above findings, we draw the following investment strategy conclusions: It is reasonable to expect a slight pickup in real estate construction activity in China over the next few months. This will be marginally positive for construction-related commodities demand. Consequently, construction-related commodities markets (steel, cement, and glass) may be supported in the near term (Chart I-15). However, over the longer term, we remain fundamentally negative on construction activity within China’s property markets, as property sales will be in a structural downtrend. BCA’s Emerging Market Strategy service recommends equity investors underweight Chinese property developers within the Chinese equity indexes (Chart I-16). Chart I-15Construction-Related Commodities May Marginally Benefit From A Pickup In Activity Chart I-16Underweight Real Estate Stocks Relative To The Domestic And Investable Benchmarks   The completion of previously launched projects will help construction-related industries. Yet, these activities will consume real estate developers’ cash augmenting their liquidity needs and amplifying their financial vulnerability. This is a basis for our recommendation to underweight property stocks, especially following their significant outperformance in the past six months.  Further, property stocks respond to marginal changes in financing conditions rather than housing sales or construction activities. The basis is that they are extremely leveraged, and access to funding is key. In the coming months, if credit conditions tighten at a time when real estate developers must commit cash to complete previously launched projects, their cash flow will deteriorate. This will be reflected in their share prices, which will underperform the Chinese broader onshore and offshore indexes. This is likely to occur regardless of the absolute performance of Chinese stocks. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      Chinese real estate developers could also slow the construction activity after completing 50% of a property project, which allows them to receive at least 60% of the presold property value from house buyers. 2      https://www.bloomberg.com/news/articles/2019-05-06/china-is-said-to-imp… 3      Please see Emerging Markets Strategy Special Report “China Real Estate: A Never-Bursting Bubble?” dated April 6, 2018 and China Investment Strategy Special Report “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. 4      Please see China Investment Strategy Special Report “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Fed: Fed policymakers are sending a unified message that they want to keep rates on hold until they see a significant increase in inflation. However, our reading of their recent remarks suggests that they will be reluctant to actually cut rates unless GDP growth falls to below its estimated potential. Economy: If we strip out the volatile net exports, government and inventory components of growth, we see that economic activity slowed to below potential in the first quarter. However, the timeliest data on consumer spending, nonresidential investment and residential investment all suggest that Q1 will be the trough for the year. All in all, economic growth should be comfortably above potential in 2019, keeping rate cuts at bay. Investment Strategy: Investors should keep portfolio duration low, avoiding the 5-year/7-year part of the Treasury curve. Investors should also overweight spread product versus Treasuries, with a focus on Baa and junk rated corporate bonds. Feature Since January, Federal Reserve policymakers have sent a strikingly unified message: Policy should remain “patient” in an effort to re-anchor inflation expectations and demonstrate the symmetry of the Fed’s 2 percent inflation target. Take for example, two excerpts from recent speeches by Boston Fed President Eric Rosengren and Chicago Fed President Charles Evans. Rosengren:1 My own preference is for the Federal Reserve to adopt an inflation range that explicitly recognizes the challenge of the effective lower bound. We might be forced to accept below-2-percent inflation during recessions, but we would commit to achieving above-2-percent inflation in good times, so as to provide more policy space to counteract the next recession. Evans:2 I think the Fed must be willing to embrace inflation modestly above 2 percent 50 percent of the time. Indeed, I would communicate comfort with core inflation rates of 2-1/2 percent, as long as there is no obvious upward momentum and the path back toward 2 percent can be well managed. The consensus appears to be not only that higher inflation is necessary before the Fed lifts rates again, but also that the Fed should explicitly target an overshoot of its 2 percent target. With trailing 12-month core PCE inflation running at only 1.55% as of March, it will undoubtedly take some time before these inflation goals are met. We think the Fed’s commitment to keeping rates steady could waver if financial conditions ease sufficiently.3 But for now, with the market priced for 36 basis points of rate cuts over the next 12 months, the more pertinent question is: What will it take for the Fed to lower rates from current levels? Expecting A Rate Cut? Don’t Hold Your Breath Our Fed Monitor has an excellent track record calling turning points in monetary policy, and at present it is very close to zero, consistent with the Fed’s “on hold” stance (Chart 1). The Monitor is comprised of 44 indicators of economic growth, inflation and financial conditions. In other words, for the Monitor to recommend rate cuts going forward we will need to see some further deterioration in either economic growth, inflation or financial markets (Chart 2). This is roughly consistent with how Chicago Fed President Evans described his reaction function in his speech from two weeks ago: Chart 1"On Hold" Stance Justified Chart 2Fed Monitor Components If growth runs close to or somewhat above its potential and inflation builds momentum, then some further rate increases may be appropriate over time… In contrast, if activity softens more than expected or if inflation and inflation expectations run too low, then policy may have to be left on hold – or perhaps even loosened – to provide the appropriate accommodation to obtain our objectives. Our interpretation of the Fed’s reaction function is that it wants to maintain an accommodative monetary policy to ensure that inflation and inflation expectations move higher over time. However, it will consider monetary policy to be accommodative as long as GDP growth stays close to, or above, estimates of its potential rate. In other words, while the Fed is in no rush to tighten, we probably need to see a significant period of below-potential GDP growth before rate cuts are on the table. In his speech, Evans indicates that his personal estimate of potential GDP growth is 1.75%. The March Summary of Economic Projections shows that the central tendency of FOMC participant estimates is 1.8% - 2%. Our view is that U.S. growth will easily surpass this threshold in 2019, keeping rate cuts at bay. Tracking U.S. Growth Markets were caught off guard last week when we learned that real GDP grew 3.17% in the first quarter, above consensus estimates and well above the 1.8% - 2% potential growth threshold. However, the headline Q1 figure was flattered by significant gains in a few volatile GDP components. Chart 3Underlying Growth Slowdown Much like how core measures of inflation strip out volatile food and energy prices to give us a better sense of the underlying trend, we can also look at Real Final Sales To Domestic Purchasers (FSDP) to get a better sense of the underlying trend in economic growth. FSDP includes only consumer spending, nonresidential investment and residential investment. That is, it removes government spending, net exports and inventory investment from the overall number. Viewed this way, we see that the U.S. economy did experience a significant growth slowdown in the first quarter. Real FSDP grew only 1.45% in Q1, below the 1.8% - 2% potential growth threshold (Chart 3). Net Exports & Inventories Chart 4Net Exports & Inventories First quarter GDP was boosted by a +1.03% contribution from net exports and a +0.65% contribution from inventory investment, neither of which is likely to be repeated in Q2 (Chart 4). The top panel of Chart 4 shows just how unusual it is to see such a large contribution from net exports, an event that becomes even less likely when you factor in the dollar’s recent appreciation (Chart 4, panel 2). Turning to inventories, a significant build was long overdue given the backlog of orders seen during the past two years. But the ISM Manufacturing Index’s backlog of orders component has now fallen back to a neutral level (Chart 4, bottom panel). This suggests that firms are comfortable with their current inventory stockpiles, and that no aggressive inventory increases are likely during the next few quarters. Interestingly, while net exports and inventories will almost certainly pressure GDP growth lower in Q2, back toward the growth rate in FSDP, the latter has probably already troughed for the year. Recent data on consumer spending, nonresidential investment and residential investment all appear to have turned a corner. Consumer Spending Consumer spending added a meager +0.8% to GDP in Q1, but core retail sales growth has recovered sharply after having plunged near the end of last year (Chart 5). What’s more, with consumer sentiment close to one standard deviation above its historical mean – whether we look at expectations or current conditions surveys – consumers don’t seem inclined to retrench in the months ahead (Chart 6). Chart 5Consumer Spending Chart 6Buoyant Consumer Sentiment Nonresidential Investment Chart 7Nonresidential Investment We expected business investment to weaken in Q1, and its +0.4% growth contribution is low compared to recent readings. The decline was anticipated due to last year’s significant deterioration in global growth. Slower global growth necessarily causes firms to downgrade their profit expectations. Faced with lower expected profits, companies are much more inclined to curtail investment. However, considering the outlook heading into mid-year, we have already noticed signs of improvement in leading global growth indicators.4 More recently, we have even seen that improvement translate into stronger U.S. investment data. Core durable goods new orders grew +17% (annualized) in March, dragging the year-over-year rate up to +5.3% (Chart 7). Further, our BCA Composite New Orders Indicator – a weighted combination of ISM New Orders and NFIB Capital Spending Plans – has bounced during the past few months, returning close to its historical mean (Chart 7, panel 3). An average of Capital Spending Intentions from regional Fed surveys also remains close to one standard deviation above its historical average (Chart 7, bottom panel). Residential Investment Residential investment (aka Housing) has exerted a meaningful drag on GDP growth in each of the past five quarters, and it lowered GDP by -0.1% in Q1 (Chart 8). However, much like with consumer spending and nonresidential investment, the timely economic data suggest a turnaround is in the offing. Much like with consumer spending and nonresidential investment, the timely economic data suggest a turnaround is in the offing. Optimism has returned to housing since mortgage rates fell earlier this year. New home sales and mortgage purchase applications have jumped, and single-family housing starts are the only important housing-related data that haven’t yet rebounded. We expect that rebound to occur soon, as do homebuilders whose confidence has risen during the past few months. Homebuilder optimism surveys remain close to one standard deviation above their historical averages (Chart 9). Chart 8Residential Investment Chart 9Buoyant Homebuilder Confidence Bottom Line: Fed policymakers are sending a unified message that they want to keep rates on hold until they see a significant increase in inflation. However, our reading of their recent remarks suggests that they will be reluctant to actually cut rates unless GDP growth falls to below its estimated potential. Potential GDP growth is estimated to be in the 1.8% to 2% range. If we strip out the volatile net exports, government and inventory components of growth, we see that economic activity slowed to below potential in the first quarter. However, the timeliest data on consumer spending, nonresidential investment and residential investment all suggest that Q1 will be the trough for the year. All in all, economic growth should be comfortably above potential in 2019, keeping rate cuts at bay. Investment Implications To translate the above views on the economy and the Fed’s reaction function into a portfolio strategy, we first return to our Golden Rule of Bond Investing.5The Golden Rule states that if the Fed delivers more (fewer) rate hikes than are currently discounted in the market over the next 12 months, then the Treasury index will earn negative (positive) excess returns versus cash during that investment horizon (Chart 10). At present, this means that investors should only expect positive excess returns from taking duration risk in the event that the Fed cuts rates by more than 36 basis points during the next 12 months. Given our view that rate cuts are unlikely, investors should maintain below-benchmark portfolio duration. Chart 10The Golden Rule's Track Record If we further assume that market expectations will shift to price-in fewer rate cuts, or even possibly some rate hikes, then we would expect 5-year and 7-year yields to rise the most (Chart 11). Investors should avoid those maturities and focus their Treasury exposure on the short and long ends of the curve. These barbell over bullet trades have the advantage of being positive carry, so they will earn money even if rate hike expectations are unchanged.6  Chart 11Avoid The 5- And 7-Year Maturities Chart 12Investment Grade Spread Targets Finally, the combination of above-potential GDP growth and a patient Fed is positive for spread product. Investors should remain overweight spread product versus Treasuries in bond portfolios, focusing on Baa and junk rated corporate bonds. Spreads for those credit tiers remain wide compared to historical median levels for this phase of the cycle (Charts 12 &13).7 Chart 13High-Yield Spread Targets Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bostonfed.org/news-and-events/speeches/2019/monetary-policymaking-in-todays-environment.aspx 2 https://www.chicagofed.org/publications/speeches/2019/risk-management-and-the-credibility-of-monetary-policy 3 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 7 For further details on how we calculate these spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The short-term trade is to overweight the DAX or Euro Stoxx 50… …versus German bunds or the S&P 500. These trades have outperformed since late last year and can continue to do so for a while longer. But moving into the second half of the year, it will be time to take profits in these growth-sensitive trades. The long-term position is to own German real estate equities. The hedged position is long German real estate equities, short Swedish real estate equities. Feature Let’s begin with a trivia question. What do Germany, Finland, and Ireland have in common, that the other EU28 countries do not have? Chart of the WeekEuro Stoxx 50 Vs. S&P500 And EM Vs. DM Have Followed Near Carbon Copy Profiles The answer: Germany, Finland, and Ireland are the only three European countries that have a trade surplus with China.1 Germany Catches A Cold When China Sneezes… Chart 2Slowdown In Germany And Finland, No Slowdown In France And Spain Germany and Finland are the European economies most exposed to China, with 17 percent and 14 percent respectively of their extra-EU28 exports heading to the dominant emerging economy (for Ireland it is only 7 percent). This equates to almost 3 percent of GDP for Germany and around 1.5 percent for Finland. Hence, when China sneezes – as it did last year – Germany and Finland are the European economies most likely to catch a cold. It is not a coincidence that Germany and Finland suffered near identical short-term slowdowns in 2018 with the pain focussed in the third quarter. By contrast, the European economies with much less exposure to China – say, France and Spain – suffered no discernible slowdown (Chart I-2). In fact, Spain seemed completely unaffected, growing at a steady and robust 2 percent clip throughout 2018! The corollary is that when China rebounds – as it has recently – Germany and Finland are the European countries most likely to benefit. Since early January, Germany’s DAX has outperformed the 10-year German bund by 15 percent. For the past three months, the DAX has also outperformed the S&P 500, albeit modestly. The trends can continue for a while, but be warned: these short-term cyclical moves are likely to reverse later in the year, perhaps viciously. More about this later. …But Germany’s Structural Growth Model Has Changed Germany’s gross exports of €1.6 trillion equate to almost half of its €3.4 trillion economy. Inevitably, this makes the German economy highly vulnerable to down-oscillations in global growth as, for example, when China sneezes. But here’s the paradox: while the level of German exports is very high, it has been flat-lining at this elevated level since 2012 (Chart I-3). Hence, Germany is no longer deriving any structural growth from its export sector. All of Germany’s post-2012 structural growth has come from domestic demand. Germany’s structural growth model has changed. Through 1999-2007, Germany’s net export contribution accounted for the vast majority of its structural growth; and in 2008, net exports accounted for two-thirds of Germany’s severe economic contraction. But remarkably, since 2012, net exports have made no contribution to Germany’s structural growth (Chart I-4). Meaning that all of Germany’s post-2012 structural growth has come from domestic demand. Chart 3The Level Of German Exports Is High But Flat-Lining Chart 4Since 2012, Net Exports Have Made No Contribution To Germany's Structural Growth One manifestation of this is the post-2012 recovery in Germany’s real estate market. When Germany was deriving most of its growth from external demand, the domestic real estate market withered. In recent years, when growth has come from domestic demand, Germany’s real estate market has started to flourish (Chart I-5). Chart 5German Real Estate Prices Still Need To Catch Up Chart 6German Real Estate Book Values Have Trebled With Germany’s average house price, in real terms, at the same level as it was in 1995, there is still considerable upside outside the major cities such as Berlin, Frankfurt, and Munich. Especially so, because one of the main enemies of the real estate market – substantially higher bond yields – will be absent for some time.2 The strong performance of German real estate equities – a near trebling since 2012 – is just tracking the strong performance of their book values (Chart I-6), which itself is a leveraged function of real estate prices. On the basis that the real estate sector is benefiting from a structural tailwind, the sector is a long-term hold, but for those who want to hedge their exposure, the recommendation is: long German real estate equities, short Swedish real estate equities. What Is Driving Euro Stoxx Outperformance? In response to this week’s title question, some people will ask: has Euro Stoxx 50 outperformance even started? The answer is a clear yes. Relative to both global equities and the S&P 500, the Euro Stoxx 50 has been in a well-established – though modest – uptrend since last September. Interestingly, emerging markets (EM) versus developed markets (DM) has followed a near carbon copy profile, albeit the outperformance was front-end loaded (Chart of the Week and Chart I-7). Euro Stoxx 50 has been gently outperforming. Can this continue? Recent history is not very encouraging. Since the Global Financial Crisis, no bout of Euro Stoxx 50 outperformance has lasted more than a year (Chart I-8). If this pattern continues to hold, it implies that the current bout of Euro Stoxx 50 outperformance will be exhausted within another four months. Chart 7Euro Stoxx 50 Has Been Gently Outperforming Chart 8Euro Stoxx 50 Vs. S&P500 ##br##Follows…   Chart 9…Euro Area Banks Vs. U.S. Tech Could it be different this time? We think not. Euro Stoxx 50 performance relative to the S&P 500 lines up almost perfectly with the relative performance of euro area banks versus U.S. tech (Chart I-9). Given that this defines the sector skew ‘fingerprint’ of the relative position, this defining relationship is fundamental. Meaning that for the Euro Stoxx 50 to outperform the S&P 500 on a sustained basis, euro area banks have to outperform U.S. tech. Likewise, EM versus DM lines up almost perfectly with the relative performance of global resources versus global healthcare (Chart I-10 and Chart I-11). Again, this is not surprising as this just defines the sector skew fingerprint of EM versus DM. Admittedly, in this case the causality could sometimes run from the EM economy to the sector performance – given China’s role in driving resource demand – rather than from sector relative performance to EM versus DM. Nevertheless, for EM to outperform DM, resources have to outperform healthcare. EM versus DM lines up almost perfectly with the relative performance of global resources versus global healthcare. Since last autumn, Euro Stoxx 50 versus S&P 500 and EM versus DM have followed near carbon copy profiles because growth-sensitive financials and resources have outperformed less growth-sensitive technology and healthcare. Chart 10EM Vs. DM Follows… Chart 11…Basic Resources Vs. Healthcare From Sweet Spot To Weak Spot Nevertheless, there is a puzzle: why have growth-sensitive sectors, the DAX, Euro Stoxx 50, and EM outperformed since late last year when the high-profile hard economic data – such as GDP growth and CPI inflation – have been unambiguously weak? High-profile hard data are a record of what happened in the past. The simple answer is that these high-profile hard data are a record of what happened in the past, sometimes the distant past. Yet they matter because central banks’ increasingly ‘data dependent’ reaction functions have become slaves to this backward-looking data. Here’s the paradox: the ‘sweet spot’ for growth-sensitive sectors and markets is when the high-profile backward-looking data – GDP and inflation – are actually weak, while real-time measures of growth – such as short-term credit impulses – are strengthening. This creates a win-win for markets because the dovish pivot by data-dependent central banks lifts asset valuations and the acceleration in real-time growth lifts profit expectations. Sound familiar? It describes the situation since last autumn, and explains why the DAX, Euro Stoxx 50, and EM have outperformed. Now comes the unfortunate corollary: the ‘weak spot’ for growth-sensitive sectors and markets is when the high-profile backward-looking data are strong, while real-time measures of growth – such as short-term credit impulses – are weakening. This is a lose-lose for markets because the hawkish pivot by central banks weighs on asset valuations and the deceleration in real-time growth depresses profit expectations. Almost certainly, this will be the situation later in the year as the high-profile hard data starts to perk up – removing some of the central bank support for valuations – just as short-term credit impulses inevitably roll over – weighing on profit growth expectations. To sum up, growth-sensitive sectors, the DAX, and Euro Stoxx 50 have outperformed since late last year, especially versus bonds and cash – in line with our house view. These trends can continue for a while longer. But moving into the second half of the year, these growth-sensitive positions will transition from sweet spot to weak spot, and it will be time to take profits. As ever, we will tell you when. Stay tuned.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* This week, we note that that the 65-day fractal dimension for technology versus healthcare is at an all-time low – implying that the recent strong outperformance is highly vulnerable to a technical reversal. Accordingly, this week’s recommended trade is short technology versus healthcare with a profit target of 6.5 percent and a symmetrical stop-loss. In other trades, we are pleased to report that long aluminium versus tin achieved its 6.5 percent profit target at which it was closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 Based on the EU28 net exports of goods to China in 2018 by Member State. 2 Please see the European Investment Strategy Weekly Report ‘Monetarists, Keynesians, And Modern Monetary Theory’ April 11 2019 available at eis.bcaresearch.com. Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Feature This week, instead of our regular Weekly Report, we will answer clients’ most frequently asked questions (FAQs) from our recent marketing trip to the old continent. Table 1 lists these questions and below we will attempt to weave a cohesive piece and answer all of these interesting questions. Clients inquiring about “how is everyone else positioned” or the related “what is the general investor sentiment like” is by far the most FAQ we always get from the road and we purposefully omit it from Table 1. Table 1Most FAQs From The Road During our last three developed markets (DM) trips, while we cannot comment on the positioning question, with regard to general investor sentiment, Australia and New Zealand are off the charts bullish. On the opposite end of the spectrum, Europe is extremely bearish, especially continental Europe. The U.S. is somewhere in the middle. Chart 1Fed’s Pivot On Display With that out of the way, the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate took center stage in our client interactions, especially the implications of the inversion for sector positioning and the duration of the business cycle. To set the record straight, a yield curve inversion does not forecast recession. Instead, it explicitly signals that the market expects the Fed’s next move to be an interest rate cut (top panel, Chart 1). In that context, the yield curve has never had a false-positive reading. Even in May 1998, it accurately forecast that the Fed would decrease the fed funds rate as it actually did in the fallout of the LTCM meltdown later that year (bottom panel, Chart 1). As equity investors, what consumes us is the SPX’s performance following the yield curve inversion. On that front, mid-December last year we showed the results of our research and made a simple observation that the yield curve inversion almost always takes place prior to the S&P peak (Table 2, Charts 2 & 3). Table 2Yield Curve Inversions And S&P 500 Peaks Chart 3…And Then The SPX Peaks In addition, today we show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in Table 3. Table 3Sector Returns From Y/C Inversion To SPX Peak While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Meanwhile, Table 4 highlights sector performance from the SPX peak until the U.S. recession hits. We first showed these results on May 22, 2018, and we are on track to publish a Special Report on May 5 on how to position portfolios at the onset of a Fed easing cycle, so stay tuned. Table 4Defensive Stocks Beat Late Investors remain infatuated with the recession signal that the yield curve inversion emits. Moreover, recent news of an onslaught of Unicorn IPOs that would bring stock supply to the equity market, near the $100bn mark on an annualized basis according to some estimates, have also brought forward recession fears, as smart money is cashing in on their investments. Chart 4 shows that $100bn per annum in IPOs has coincided with the SPX peak in the previous two cycles. Our long-held view remains that either a mega M&A deal in the tech or biotech space or Uber’s IPO at a stratospheric valuation could serve as the anecdote that confirms the current cycle’s peak. On the yield curve front specifically, the top panel of Chart 5 shows that the most important yield curve, the 10/2, has not yet inverted. Moreover, the 30/10 and the 30/5 slopes are steepening. True, we are late cycle, but we need all the slopes to invert to get a confirmation that the recession is a foregone conclusion. Chart 4Mind The Excess Supply Chart 510/2 Y/C Has Yet To Invert The Fed’s tightening cycle has not only inverted most parts of the yield curve starting early last December, but has inflicted some damage on profit margins. Following up from our recent profit margin work highlighting nil corporate pricing power at a time when wage costs are perking up, BCA’s Monetary Indicator signals more SPX margin pain in the coming months (Chart 6). In fact, sell-side estimates call for another three consecutive quarters of a year-over-year contraction in profit margins. Chart 6Margin Trouble In more detail, the earnings deceleration that commenced in Q4 2018 and is gaining steam is disconcerting. As a reminder, Q4 included the lower corporate tax rate and the Q/Q deceleration is not solely due to the tech sector profit warnings. Eight out of the 11 GICS1 sectors sharply decelerated, two modestly accelerated and only industrials steeply accelerated to a cyclical EPS peak growth rate (Table 5). This EPS breadth deterioration is eerily reminiscent of early-2015 (Chart 7) and is disquieting. Short-term caution is also warranted given the increase in investor complacency. The one sided positioning in the VIX futures market is worrisome. As a reminder, net speculative positions are now at a lower low than the February 2018 level when the VIX snapped to over 50 and caused a massive tremor in the equity market (net speculative positions shown inverted, Chart 8). Table 5Historical/Current/Future Earnings Growth Rates Chart 7Bad Breadth Chart 8Too Complacent But, before getting overly bearish there are some growth green shoots that suggest that Q2-to-Q3 will likely mark the trough in EPS/EBITDA growth and margins (Chart 9). Beyond these positive leading profit indicators, a resolution to the U.S./China trade tussle and China’s trifecta of policy easing measures will also aid in turning profit growth around and really power up U.S. cyclicals’ EPS growth rates. Following up from the January Fed meeting, on February 4 we penned a report titled “Don’t Fight The PBoC” and it is now clear with the recent manufacturing PMI release that China’s easing on all three fronts – credit (Chart 10), monetary (Chart 11) and fiscal (Chart 12) – is starting to pay some dividends. In that light, the U.S. cyclicals vs. U.S. defensives recent outperformance has more room to run. Chart 9Growth Green Shoots Chart 10Chineasing… Chart 11...On All… Chart 12…Fronts   Deep cyclicals have another major advantage this cycle compared with defensives. While at this stage of the business cycle one would expect capital intensive businesses to become debt saddled, cyclicals are still de-levering from the depths of the late-2015/early-2016 manufacturing recession, i.e. paying down debt and increasing cash flow. Defensives, however, are doing the exact opposite with relative cash flow growth problems and piling on debt. Thus, on a relative basis Chart 13 shows that the indebtedness profile clearly favors deep cyclicals vs. defensives. From a bigger picture perspective, while the U.S. has not really purged any debt and it has just shifted it around from the financial and household sectors to the non-financial business and government sectors (Chart 14), the near all-time high in non-financial business sector credit as a share of GDP is disconcerting (top panel, Chart 14). Clearly the excesses are in this segment of U.S. debt and it is unsurprising that debt saddled stocks have been underperforming equities with pristine balance sheets since the 2016 presidential elections (top panel, Chart 15). Such outperformance has staying power, especially given that we are late in the cycle and the Fed has raised interest rates to the point where parts of the yield curve are inverted and a default cycle looms large (bottom panel, Chart 15). Chart 13Cyclicals Have The Upper Hand Chart 14U.S. Debt Profile Breakdown One sub-sector that epitomizes the current cycle’s excesses is commercial real estate (CRE). CRE prices have overshot the historical time trend by almost two standard deviations and it has already been three and a half years since they surpassed the previous all-time high (Chart 16). The recent pullback in the 10-year Treasury yield has pushed cap rates even lower and the bubble in CRE is further inflated. Looking back at the late-1980s pricking of that CRE bubble is instructive and when this cycle ends a big deflationary impulse will likely deal a blow to the CRE market.       Chart 15Hide In Pristine Balance Sheets Chart 16CRE Excesses Are A Yellow Flag Speaking of bubbles, the biggest bubble we currently see is not in equities, but in bonds. Table 6 shows that red is taking over and is reminiscent of mid-year 2016 when the 10-year U.S. Treasury yield troughed a hair above 1.3%. Globally, negative yielding debt is near all-time highs (Chart 17) and the excesses are even larger in the EM sovereign space and in select DM corporates. Mexico raising century debt in U.S. dollars, in cable and in euros is perplexing, as Mexico was at the epicenter of the 1982 LatAm crisis and again in 1994 with the Tequila crisis. Argentina also raising century debt recently in hard currency speaks to the magnitude of the current bond bubble. On the corporate side, Sanofi and LVMH placing negative yielding debt is beyond our understanding, or Total issuing a perpetual bond with a 1.75% coupon. Table 6Red Takes Over   Chart 17Bonds Are In A Bubble All of this is likely linked to the unintended consequences of global QE where fixed income investors are pushed out the risk spectrum and are forced into buying riskier credit. When this bond bubble gets pricked it will end in tears as it always does and the catalyst will likely be the next U.S. recession that will cause a global recession. While our cyclical 9-to-12 month equity market view is constructive and we believe the U.S. will avoid recession, our structural 1-to-3 year view is negative. Nevertheless, we constantly challenge our thesis and the biggest pushback to the negative structural view is the following: What if the Fed can engineer a soft landing in the U.S. as it did twice in the mid-1990s, and the business cycle runs hot for another 5 years (Chart 18)? What if the starting point of low interest rates with the real fed funds rates still close to zero is very stimulative for the U.S. economy as no recession has ever started with a fed funds rate perched near zero (Chart 19)? Finally, what if the late-2015/early-2016 manufacturing recession was actually an economic recession despite the fact that the NBER did not designate it as such and the business cycle got reignited, especially with President Trump’s election that lifted animal spirits? As a reminder, while S&P profits have contracted outside of an economic recession twice before, SPX sales had never achieved that feat, until late-2015/early-2016 (Chart 20). In other words, the revenue recession we had was unprecedented and felt like an economic recession. Chart 18The Fed Has Engineered A Soft Landing Chart 19Stimulative Real Rates Chart 20There Is Always A First Time If that were the case and the cycle were to extend into the 2020s, then the risk is that SPX EPS vault to $200 and valuations overshoot, i.e. the forward P/E multiple spikes to a 20 handle and the SPX catapults to 4,000. In that case, we would leave 1,000 points on the table and our SPX 3,000 view would be way offside. While this is a risk to our negative structural view, there are two sectors we really like for the long-term as we deem them secular growth plays and should do exceptionally well on a 10-year horizon: software and defense stocks. Three key drivers underpin our bullish view on software: galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A (Chart 21). Most importantly, the move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are in a structural uptrend. With regard to defense stocks, the three key pillars we highlighted in our “Brothers In Arms” Special Report on October 31, 2016 remain intact: the global rearmament is still gaining steam, a space race with manned missions to the moon now includes the U.S., China and India, and cybersecurity is a real threat for governments around the world (Chart 22). On all three fronts, defense stocks stand to benefit as they have beefed up their offerings to provide governments with a one-stop shop solution covering most of these needs. Chart 21Buy The Software Breakout Chart 22Defense Stocks Remain A Long-term Buy     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com

Highlights We are asked nearly everywhere we go about the Fed’s independence, … : The Fed’s independence is an especially popular topic overseas, and it typically takes some persuasion to bring clients around to our view that it’s not at risk. … and Jay Powell shed some light on how the Fed intends to protect it: Since Bernanke, the Fed has fought back against criticism by attempting to open a window on its operations, and showing how they benefit all Americans. Powell’s Stanford speech and 60 Minutes appearance continued the transparency and charm offensive. The housing debate remains unresolved, but year-to-date activity has supported our sanguine outlook: Demand came back smartly following the decline in mortgage rates, and there is still no sign of overheating or oversupply on the horizon. Coincident indicators have a place, too: We do not include the three-month moving average of the unemployment rate in our recession indicator because it’s only a coincident indicator, but it does help to validate the leading indicators we follow. Feature BCA was established on our founder’s insight that tracking money flows through the banking system informs the future direction of the economy and financial markets. Monetary policy is of the utmost importance to BCA as a firm, and the fed funds rate cycle is a pillar of our U.S. Investment Strategy asset-allocation framework. That said, spending time parsing Fed speeches can be unavailing and tedious. Although we continually monitor comments from the Fed governors and regional bank presidents, we don’t often write about them. Since last summer, when the President first began expressing his displeasure with the Fed 140 characters at a time, we have been inundated with questions about the Fed’s independence, especially from overseas clients. We have noted repeatedly that conflicts between the White House and the Fed are nothing new. They are largely inevitable, and highlight the importance of insulating central banks from political pressure. A recent television interview and speech by Fed Chair Powell illustrated how the Fed hopes to safeguard its independence. The speech also sketched out some of the arguments supporting a potential re-interpretation of the Fed’s price stability mandate. If the Fed really were to pursue some sort of price-level targeting, the implications could be profound. TRIGGER ALERT: The following sections may promote cardiac distress among Austrian School devotees and other hard-money types. An Open, Friendly Fed Fed Chair Jerome Powell sat for an extended interview with venerable U.S. television news magazine 60 Minutes, broadcast in prime time Sunday March 10th. His comments carried no new information for Fed watchers, but appearances on 60 Minutes are not intended for Fed watchers, any more than Janet Yellen’s stop to watch community college students welding on her first official trip as Chair was. Powell appeared briefly alongside Yellen and Ben Bernanke in the 60 Minutes segment, and his appearance followed his predecessors’ public-relations game plan closely: defend the Fed’s independence, and explain the Fed’s role in managing the economy, so as to dispel some of the mystery about its mission and modus operandi. It was Bernanke who first sat for 60 Minutes, in 2009 and 2010, attempting to broadcast the Fed’s aims to the general public. Yellen extended the public outreach, as we noted in these pages five years ago, following her debut appearance:1 Not only did she make her first major outside appearance at a community development conference, she placed the plight of three locals grappling with unemployment and/or underemployment at the center of her remarks. She dined at a community-college training restaurant on the night before the speech, and went to another community college after delivering it, where she visited a shop floor and watched students weld. One could easily have mistaken her for a candidate for public office, given the photo ops and her dogged efforts to drive home the message that the labor market heads the Fed’s list of concerns. A New Take On Price Stability Powell’s 60 Minutes interviewer occasionally went out of his way to express skepticism about the Fed and its pre-crisis performance. A voiceover pointed to Powell’s academic record and Wall Street experience as signs of privilege, rather than evidence of aptitude or acumen. As Powell noted in a speech at Stanford University two days before the 60 Minutes interview aired, the current climate is one of “intense scrutiny and declining trust in public institutions” globally. Outwardly welcoming the scrutiny, and seeking to shore up the public’s trust, the Fed plans to hold a series of town-hall-style “Fed Listens” events around the country. The post-crisis Fed has tried to protect its independence by becoming more transparent. The Fed’s listening tour will be a part of its year-long review of monetary policy strategy, tools and communication practices, but we were most interested in Powell’s comments on strategy as it relates to the Fed’s price-stability mandate. Concerned that the secular decline in rates will regularly make the zero lower bound a binding policy constraint, the Fed is exploring the potential for some sort of price-level-targeting strategy. As a part of its review, it is asking, “Can the Federal Reserve best meet its statutory objectives with its existing monetary policy strategy, or should it consider strategies that aim to reverse past misses of the inflation objective?” When targeting the inflation rate, the Fed hasn’t much sweated inflation undershoots. Price-level targeting would represent a significant change from managing to the 2% annual inflation target on a non-cumulative basis. As shown in Chart 1, the Fed has executed its price-stability mandate by aiming for 2% annual inflation, as measured by the headline PCE price index. In theory, each year-over-year change is an independent event, considered without regard to prior overshoots or undershoots. The post-crisis shortfalls have no explicit bearing on the price-stability goal going forward, though perhaps they have made the Fed a little more inclined to wait until it sees the whites of inflation’s eyes before it removes accommodation in earnest. Chart 1Traditional Policy Has Been Directed At Keeping Prices From Rising Too Fast ... A price-level-targeting framework, on the other hand, would take its cues directly from past overshoots and undershoots. Whereas the Fed simply aimed at 2% every year in the old regime, under price-level targeting, it would be attempting to stay in continual contact with the 2% trend-growth line in Chart 2. Had price-level targeting been in place since the crisis began, the cumulative misses from 2008 on would eventually have to be made up. If the price-level target were to be reached by the end of this year, 2019 inflation would have to be 8.1%; by the end of next year, annualized inflation would have to be 5%; in five years, 3.2%; and in ten years, 2.6% (Table 1). Chart 2... Price-Level Targeting Seeks To Ensure They've Risen Enough Table 1Price-Level Targeting Higher inflation rates would presumably push Treasury bond volatility higher (Chart 3, top panel), along with the term premium (Chart 3, bottom panel). The increased uncertainty inherent in hitting a moving target would also help stoke interest-rate volatility, which would ripple out into the rest of financial markets. The Fed wouldn’t deliberately pursue a policy that stokes volatility unless it delivers other significant benefits. By boosting inflation expectations, price-level targeting could help stave off a deflationary mindset like the one that has crippled Japan since the bursting of its bubble three decades ago. More immediately, it could help combat the secular stagnation effects Larry Summers has been warning about for the last several years by making it easier for the Fed to reduce real rates. Chart 3Lower Inflation Has Helped Tamp Down Treasury Volatility And The Term Premium There is no sign that a change in the Fed’s monetary policy strategy, as it relates to price stability, is coming. The Fed performs a great deal of research and develops hypothetical game plans for a wide range of hypothetical economic outcomes. Discussions about price-level targeting are only conceptual for now, and the Fed will not necessarily adopt it. If price-level targeting were to become mainstream policy, it might better equip central banks with a tool for counteracting disinflationary impulses and could turn out to be marginally equity-friendly and bond-unfriendly. If it were to shift to a price-level-targeting framework, the Fed would be equally concerned about undershoots and overshoots. Housing Update We were unperturbed by the softness in the U.S. housing market when we published our housing Special Reports late last year. Three months into 2019, the data have supported our view, and we remain confident that the housing market does not represent the leading edge of an imminent downturn. We expect price-level targeting would increase financial-market volatility, at least when it’s first implemented. We highlighted in those Special Reports2 that the share of residential investment as a percentage of GDP has been steadily decreasing over the past 70 years, and is down to just 3% today. Although housing remains an important component of the U.S. economy and large fluctuations in the space will surely impact other segments of the economy, it is unlikely to exert a powerful drag. Home values also comprise a sizable portion of households’ net worth, and a decline in house prices will affect consumption patterns, but investors probably exaggerate the impacts. Housing now accounts for less than 15% of household equity – well below its 1980s and 2006 peaks – whereas pension entitlements and direct and indirect equity holdings account for 25% each. The rate at which mortgage rates change can exert a powerful impact on home sales and residential construction activity. 2018’s soft housing data was likely the byproduct of the yearlong rise in mortgage rates. Home sales and construction tend to decline in the six-month period after mortgage rates rise (Chart 4). Although higher mortgage rates took a toll on housing affordability last year, it remained at comfortable levels relative to history, and has already regained a good bit of ground now that the 30-year mortgage rate has declined by half a percentage point since its November peak. Mortgage applications have duly picked up since the end of last year. Chart 4Mortgage Rates Hurt Housing Last Year, But Are Poised To Help It This Year Most importantly for the overall economy, there is no evidence of construction excess. In contrast to the decade preceding the crisis, there is still plenty of room for new supply as housing starts still lag the pace of new household formations. New-home inventories have increased, but only back to their pre-housing boom range, and they amount to no more than a fraction of existing-home inventories, which are bumping around 30-year lows (Chart 5). The aggregate supply of homes for sale is not at all a matter for concern. Chart 5Housing Inventory Levels Are Low Bottom Line: The outlook for the housing market has improved since the end of the year. Homes remain affordable relative to history, and the aggregate inventory of homes for sale is the lowest it’s been since the mid-‘90s. The housing market still looks okay to us. Unemployment Is A Coincident Indicator We received a question from a client following last week’s review of our bond-upgrade and equity-downgrade checklists. Why do we include the three-month moving average of the unemployment rate in the equity checklist, but not our recession indicator? The simple answer is that the recession indicator is meant to be forward-looking.3 The unemployment measure has a sterling track record of coinciding with recessions, but it does not lead them (Chart 6). Chart 6A Coincident Indicator The three components of our recession indicator – an inverted yield curve, year-over-year contraction in the Leading Economic Indicator (LEI), and an above-equilibrium fed funds rate – have all consistently preceded recessions (Table 2). When combined into a single indicator, they’ve done so an average of just over six months before the onset of recessions, in line with the S&P 500’s average peak. The unemployment rate has been a coincident indicator, sending its signal an average of just under a month after recessions begin (Table 3). Table 2Lead Times For Indicator Components And Bear Markets Table 3Unemployment And Postwar Recessions The unemployment rate’s three-month moving average has a perfect record of coinciding with recessions, but indicators have to lead to be included in our recession alarm system. Tacking on an extra month to account for the lag in the data release, the unemployment rate alerts an investor to a recession two months after it’s begun. That’s too late to help sidestep the brunt of the S&P 500’s bear-market declines, so we leave it out of our recession indicator. Unemployment’s recession signal is nonetheless a good bit more timely than the NBER’s official recession declaration, which has come an average of eight months after the start of the last five recessions. The three-month moving average of the unemployment rate provides reliable confirmation that recessions have begun, and that has earned it a place in our equity checklist. Doug Peta, CFA   Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com Footnotes 1      Please see the April 7, 2014 U.S. Investment Strategy Weekly Report, “Fed To America: We Care.” Available at usis.bcaresearch.com. 2      Please see the November 19, 2018 and December 3, 2018 U.S. Investment Strategy Special Reports, “Housing: Past, Present And (Near) Future,” and “Housing Seminar.” Available at usis.bcaresearch.com. 3      Please see the August 13, 2018 U.S. Investment Strategy Special Report, “How Much Longer Can the Bull Market Last?” Available at usis.bcaresearch.com.

Key Portfolio Highlights The S&P 500 has started 2019 with a bang as dovish cooing from the Fed has proven a tonic for equities. While we have not entirely retraced the path to the early-autumn highs, our strategy of staying cyclically exposed, based on our view of an absence of a recession in 2019, has proven a profitable one as investor capitulation reached extreme levels (Charts 1 & 2). Chart 1CapitulationChart 2Selling Is Exhausted Importantly, risk premia have been deflating as the end-of-year spike in volatility has subsided and junk spreads have narrowed from the fear-induced heights in December (Chart 3). Chart 3Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A continuation of the earnings juggernaut A positive U.S./China trade resolution With respect to the first of these, the S&P 500 convulsed following the December 19 Fed meeting and suffered a cathartic 450 point peak-to-trough fall two months ago. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Charts 4 & 5). Chart 4Powell's Resolve Getting Tested Chart 5Fed Policy Mistake The rising odds of a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome respite for equities. Our second catalyst has been gaining steam through the Q4 earnings season which has seen continuation of the double-digit earnings growth of the prior three quarters. Our earnings model points to a moderation of earnings growth in the year to come, in line with sell-side expectations (Chart 6). Our 2019 year-end target remains 3,000 for the SPX, based on $181 2020 EPS and a 16.5x multiple.1 This represents a 6% EPS CAGR, assuming 2018 EPS ends near $162. Chart 6EPS Growth > 0 In Chart 7, we show that financials, health care and industrials are responsible for 61% of the SPX’s expected profit growth in 2019 while technology’s contribution has fallen to a mere 7.2%. While the risk of disappointment encompases financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 8 & 9). Chart 8Earnings Revisions... Chart 9...Really Weigh On Tech Lastly, the negativity surrounding the slowdown in China is likely fully reflected in the market (Chart 10), implying an opportunity for a break out should a positive resolution to the U.S./China trade spat be delivered. China’s reflation efforts suggests that the Chinese authorities remain committed to injecting liquidity into their economy (Chart 11). Chart 10China Slowdown Baked In The Cake Chart 11Reflating Away Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (Chart 12). All of these underlie our style preferences for cyclicals over defensives2 and international large caps over domestically-geared small caps. Chart 12Heed The PBoC Message Chris Bowes, Associate Editor chrisb@bcaresearch.com S&P Financials (Overweight) The divergence between the directions for our CMI and valuation indicator (VI) for S&P financials has reached stunning levels, with the former accelerating into pre-GFC territory and the latter falling to two standard deviations below fair value. Our technical indicator (TI) is sending a relatively neutral message, though this does not diminish the most bullish signal in our cyclical indicator’s history (Chart 13). Chart 13S&P Financials (Overweight) The ongoing strength of the U.S. economy is the driver of such a positive indicator, particularly with respect to the key S&P banks sub index. Our total loans & leases growth model and BCA’s C&I loan growth model (second & bottom panels, Chart 14) are in positive territory. The latter is significant given that C&I loans are the single biggest credit category in bank loan books. Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Further, multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 14). In the context of the generationally high employment rate, the implied lower defaults should drive amplified profit improvement from this credit growth. We reiterate our overweight recommendation. Chart 14Loan Growth Drives Profits S&P Industrials (Overweight) The still-solid domestic footing has maintained our industrials CMI close to its cyclical highs, which are also some of the most bullish in the history of the indicator. However, stock prices have not responded accordingly and our VI has descended mildly from neutral to undervalued. Our TI sends a much more definitive message and stands at a full standard deviation into oversold territory (Chart 15). Chart 1515. S&P Industrials (Overweight) While their cyclical peers S&P financials are almost exclusively a domestic play, S&P industrials have been weighed down by trade flare ups for most of the past year (bottom panel, Chart 16). Accordingly, much of the benefit of positive domestic capex indicators and the more tangible capital goods orders maintaining a supportive trajectory has failed to show up in relative EPS growth (second & third panels, Chart 16), though the latter has recently hooked much higher. Chart 16Industrial Earnings Growth Has Recovered S&P Materials (Overweight) Our materials CMI has made a turn, rising off its lowest level in 20 years. This has coincided with our VI bouncing off its cyclical low, though it remains in undervalued territory. The signal is shared by our TI which has only recently recovered from a full standard deviation into the oversold zone, a level that has historically presaged S&P materials rallies (Chart 17). Chart 17S&P Materials (Overweight) When we upgraded the S&P materials sector to overweight earlier this year, we noted that China macro dominates the direction of U.S. materials stocks. On the monetary front, the Chinese monetary easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 18). The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNY/USD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 18). Chart 18Chinese Data Drives Materials Performance S&P Energy (Overweight) Our energy CMI has moved horizontally for the past six quarters, though this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Meanwhile both our VI and TI have descended steeply into buying territory with the former approaching two standard deviations below fair value (Chart 19). Chart 19S&P Energy (Overweight) As with the CMI, the relative share price ratio for the S&P energy index has moved laterally since our mid-summer 2017 upgrade to overweight. Interestingly, the integrated oil & gas energy subindex neither kept up with the steep oil price advance until the end of September, nor with the recent drubbing in crude oil prices (top panel, Chart 20). Put differently, oil majors never discounted sustainably higher oil prices, and are also refraining from extrapolating recent oil prices weakness far into the future. Chart 2020. The Stage Is Set For A Recovery In Crude Prices Nevertheless, the roughly 30% per annum growth in U.S. crude oil production is unsustainable and, were production to remain near all-time highs and move sideways in 2019, then the growth rate would fall back to the zero line. Such a paring back in the growth rate would likely balance the oil market and pave the way for an oil price recovery (oil production shown inverted, bottom panel, Chart 20). This echoes BCA’s Commodity & Energy Strategy service, which continues to forecast higher oil prices into 2019, a forecast which should set the stage for a sustainable rebound next year in S&P energy profits, the opposite of what analysts currently expect (Chart 7). S&P Consumer Staples (Overweight) An improving macro environment is reflected in our consumer staples CMI that has vaulted higher in recent months. However, the strong recent relative outperformance has also shown up in our VI which, though still in undervalued territory, has recovered significantly. Our TI has fully recovered and now sends a neutral message (Chart 21). Chart 21S&P Consumer Staples (Overweight) The surging S&P household products sector has been carrying the S&P consumer staples index on its back as solid pricing efforts have been dragging results and forward guidance higher. While household product sales have been enjoying a multi-year growth phase (second panel, Chart 22), it has largely been driven by volumes. However, the recent resurgence in pricing power (third panel, Chart 22) has given volume gains an added kick, pushing sales further. Meanwhile, exports have continued their two-year ascent despite the tough currency environment and the upshot is that relative EPS growth will likely remain upbeat (bottom panel, Chart 22). In light of challenged EM consumer spending growth, this signal is very encouraging. Chart 22Household Products Is Carrying Staples S&P Health Care (Neutral) Our health care CMI has been treading water recently. Further, a recovery in pharma stocks has taken our VI from undervalued to a neutral position, while our TI sends a distinctly bearish message as health care stocks have been overbought (Chart 23). Chart 23S&P Health Care (Neutral) Healthcare stocks have outperformed in the back half of 2018. Recently a merger mania that has swept through the pharma and biotech spaces has underpinned relative share prices. The last three months have seen an explosion of deals, including the largest biopharma deal ever (Bristol-Myers Squibb buying Celgene for approximately $90 billion) with other global deals falling not too far behind (Takeda buying Shire for $62 billion mid-last year). Such exuberance has clearly confirmed that merger premia are alive and well in the S&P pharma index. It is not merely rising premia that have taken pharma higher either. Pricing power has entered the early innings of a recovery (top panel, Chart 24) while the key export channel points to increasingly bright days ahead (second panel, Chart 24). However, the rise of regulatory pressure from the Trump administration may cause better pricing to prove fleeting. Chart 24Merger Mania In Pharma Further, pharma’s consolidation phase has come at a cost to sector leverage ratios that have dramatically expanded (bottom panel, Chart 24). Such profligacy may come to haunt the sector should the pricing power recovery falter. S&P Technology (Neutral) Our technology CMI has been moving laterally for the better part of the last three years, though the S&P technology index has ignored the macro headwinds and soared higher over that time. Our VI remains on the overvalued side of neutral, despite the recent tech selloff while our TI has been retrenching into oversold territory (Chart 25). Chart 25S&P Technology (Neutral) Until the end of last year, we maintained a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. However, we recently upgraded the niche semi equipment to overweight for three reasons. First, trade policy uncertainty has dealt a blow to this tech subindex. Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Second, emerging market financial indicators are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (second panel, Chart 26). Third, long term semi equipment EPS growth estimates have recently collapsed to a level far below the broad market, indicating that the sell side has thrown in the towel on this niche sector (third panel, Chart 26). Chart 26A Bottom In Semi Equipment Overall, and despite our more bullish view on semi equipment, we continue to recommend a neutral weighting in S&P technology. S&P Utilities (Underweight) Our utilities CMI has recovered recently, bouncing off its 25-year low, driven by the modest easing in interest rates, (Chart 27). This has also manifested in a recovery in the S&P utilities index as this fixed income proxy has reacted to the recent fall in Treasury yields (change in yields shown inverted, top panel, Chart 28) and jump in natural gas prices. Further, utilities are typically seen as a domestic defensive play and the recent trade troubles have made utilities soar in a flight to safety. Chart 27S&P Utilities (Underweight) We think the tailwinds lifting utilities are transitory and likely to shift to headwinds. First, one of our key themes for the back half of the year is rising interest rates; a move higher in yields will have a predictably negative impact on these high-dividend paying equities. Second, a flight to safety looks fleeting; the ISM manufacturing new orders index usually moves inversely in lock step with utilities and the most recent message is negative for the S&P utilities index (ISM manufacturing new orders index shown inverted, second panel, Chart 28). Meanwhile, S&P utilities earnings estimates have continued to trail the broad market, having taken a significant step down this year (third panel, Chart 28). Chart 28Rising Rates In Late-2019 Will Be A Headwind For Utilities Our VI and TI share this bearish message as the VI is deeply overvalued and the TI is in overbought territory (Chart 27). S&P Real Estate (Underweight) Our real estate CMI has recently started to turn up, though this is off the near decade-low set last year and remains deeply depressed relative to history (Chart 29). This is principally the result of the backup in interest rates since late last year and the lift they have given to the sector, which has been a relative outperformer over the past six months (top panel, Chart 30). Much like the S&P utilities sector in the previous section, and in the context of BCA’s higher interest rate view, we continue to avoid this sector. Chart 29S&P Real Estate (Underweight) Along with the modest reprieve in borrowing rates, multi family construction continues unabated (second panel, Chart 30), likely driven by all-time highs in CRE prices (third panel, Chart 30). In the absence of an outright contraction in construction, recent weakening in occupancy (bottom panel, Chart 30) will likely prove deflationary to rents, and thus profit prospects. Chart 30Falling Occupancy Will Hurt REIT Profits Our VI suggests that REITs are modestly overvalued, though the recent outperformance has driven our TI to an overbought condition (Chart 29). S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI has ticked up recently, pushed higher by resiliency in consumer data. However, the S&P consumer discretionary index has clearly responded, pushing against 40-year highs relative to the S&P 500 and taking our VI to two standard deviations above fair value (Chart 31). Much of this should be attributed to Amazon (roughly 30% of the S&P consumer discretionary index) and their exceptional 12% outperformance relative to the broad market over the past year. Chart 31S&P Consumer Discretionary (Underweight) While we have an underweight recommendation on the S&P consumer discretionary index, we have varying intra-segment preferences, highlighted by the recent inception of a pair trade going long homebuilders and short home improvement retailers (HIR). Housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (top & middle panels, Chart 32). Further, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (momentum in lumber prices shown inverted and advanced in bottom panel, Chart 32). Chart 32Long Homebuilders / Short Home Improvement Retailers S&P Communication Services (Underweight) As the newly-minted communication services has little more than four months of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 33 with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Chart 33S&P Communication Services (Underweight) Rather, we refer readers to our still-fresh initiation of coverage on the sector3 and look forward to being able to deliver something more substantive in the future. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years (Chart 34). Despite the neutral CMI reading, we downgraded small caps in the middle of last year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (bottom panel, Chart 35). This size bias remains a high conviction call for 2019. Chart 34Favor Large Vs. Small Caps Macro data too has turned against small caps. Recent NFIB surveys have shown that small business optimism has continued to fall through the end of the year, albeit from a very high level (top panel, Chart 35). This has coincided with the continued slide of small cap stocks relative to their large cap peers. Chart 35Small Caps Have A Big Balance Sheet Problem Further, the percentage of small businesses with planned labor compensation increases continues to set new all-time highs and deviates substantially from the national trend (second panel, Chart 35). This divergence becomes more worrying when plotted against those same firms increasing prices (third panel, Chart 35), which has trailed for some time and recently flattened. The inference is that margin pressure is intensifying and likely to continue for the foreseeable future. In the context of the absence of small cap balance sheet discipline during the past five years, ongoing large cap outperformance seems ever more likely. Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “ Catharsis,” dated January 14, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “ Don't Fight The PBoC,” dated February 4, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Daily Insight, “New Lines Of Communication,” dated October 1, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Daily Insight, “Small Caps Have A Big Balance Sheet Problem,” dated May 10, 2018, available at uses.bcaresearch.com.