Equities

Highlights Did October's equity rout ... : Before bouncing back in its final two sessions, October was the S&P 500's 12th-worst month of the postwar era. ... represent a watershed for financial markets?: Shaken investors have begun asking if the equity bull market is finally over, and if Treasury yields are in the process of making their cyclical highs. Not according to the macro backdrop, which still supports risk assets, ... : There is no recession in sight. An earnings contraction sufficient to induce an equity bear market, or a meaningful pickup in defaults, isn't imminent. ... or our rates checklist, which still supports a bearish take: Inflation may be taking its time, but nothing on our rates checklist calls for increasing duration in a bond portfolio. Feature U.S. equity investors were relieved to close the books on October, which was a notably bad month for the S&P 500. Its 7% loss was good for 33rd-worst in the postwar record books, and just missed being a -2 standard-deviation event. Had the month ended before its robust bounce in the final two sessions, it would have been the 12th-worst, two-and-a-half standard deviations below the mean (Chart 1). At its lowest point, a half-hour before the October 29th close, the index was down a whopping 10.5% for the month. Chart 1Standing Out From The Crowd The price action understandably unnerved investors. Monthly declines of this magnitude are almost always associated with bear markets; just seven of the thirty-two larger declines occurred outside of bear markets, two of them by the skin of their teeth. Decomposing the equity returns into changes in earnings estimates and changes in forward multiples shows that sharp multiple contraction is a feature of nearly every bad month (Table 1). Table 1Worst Postwar Monthly Declines It is estimate growth - a robust 0.8% - that makes October something of an outlier among the S&P 500's worst months, and we expect growing forward earnings will keep the S&P out of a bear market for another year, especially now that its multiple is more than 15% off its peak. Earnings growth should also keep spread product out of trouble for the time being. Although we recommend no more than an equal weight in corporate bonds, modest spread widening has boosted their total return prospects. Too Legit To Quit We expect that earnings will keep growing because they rarely contract in a meaningful way outside of recessions. With monetary accommodation likely reinforcing certain fiscal stimulus over the coming year, it is hard to see how the next U.S. recession will occur before 2020. As our U.S. bond strategists pointed out last week, the ongoing market implications of last month's equity decline depend on what precipitated it.1 Was it a simple correction sparked by a valuation reset, or has the market begun to sniff out an economic slowdown? With forward four-quarter earnings growing by an annualized 9.5% in October, it appears that the selloff was nothing more than a valuation reset. As our bond strategists point out, the picture was much different when the S&P 500 corrected in the summer of 2015 and the winter of 2015-16. Those corrections unfolded against the backdrop of a global manufacturing recession (Chart 2). The U.S. economy is not bulletproof, and slowing global growth and tighter financial conditions will eventually bring it to heel, but we think the next recession is still too far down the line for markets to begin selling off in advance of it. Chart 2The Fundamentals Are Much Improved From 2015-16 Checking In With Our Rates Checklist If macro conditions really did change for the worse last month, our bearish rates view may no longer apply, and we would have to rethink our underweight Treasury and below-benchmark-duration calls. We introduced our rates checklist in September to identify and track the key series that could trigger a view change. We review it now to see if perceptions of the Fed, inflation measures, labor-market developments, or financial-market excesses suggest that rates may be at a turning point (Table 2). Table 2Rates View Checklist Market Perceptions Of The Fed We continue to scratch our head over markets' refusal to take the FOMC's terminal-rate projections seriously. The overnight index swap (OIS) curves are calling for a measly two hikes over the next 12 months ... and the next 18 months ... and the next 24 as well (Chart 3). That would leave the terminal fed funds rate for this tightening cycle at a mere 2.75%. The median projection among FOMC voters is 3 1/8%, and we're looking for anywhere from 3.5 to 4%. We will have to start backing off once the gap between our expectations and the market's expectations begins to close, but it's only widened since we established the checklist. Chart 3Stubbornly Staying Behind The Curve We get to our 3.5-4% estimate on the premise that measured inflation will pick up enough to force the Fed to keep hiking beyond its own expectations in a bid to keep inflation from getting out of hand. Client meetings suggest that investors find our inflation call hard to swallow. Some eye-rolling when we mention the Phillips Curve is understandable, but our view is ultimately based on capacity constraints. Tepid investment in the years following the crisis have left the economy's productive potential ill-suited to meet the surge in aggregate demand provoked by tax cuts and fiscal stimulus. An inverted curve would indicate that the bond market has begun to anticipate that rate hikes will soon stifle the economy's momentum. For all the hand-wringing in the media about flattening over the 2-year/10-year segment of the curve, our preferred 3-month/10-year measure remains nowhere near inverting (Chart 4). The yield curve tends to invert way ahead of a recession, so we would look for other indicators to corroborate its message before we changed our big-picture take. We also note that a bear flattening would support below-benchmark-duration positioning. Chart 4The Fed Hasn't Gone Too Far Yet Bottom Line: The bond market remains well behind the Fed, and the Fed may well wind up behind the economy. A broad repricing of the Treasury curve awaits. Inflation Measures Inflation's slow creep has gotten a little slower since we initially rolled out the checklist. Headline PCE and CPI have hooked downward, though their uptrends remain intact (Chart 5). Looking forward, continued tightening of the output gap should boost inflation (Chart 6), though long-term expectations have stalled for now (Chart 7). Inflation is the only section of the checklist that has backslid since September, but not by nearly enough to justify checking any of the boxes. Chart 5Two Steps Forward, One Step Back Chart 6An Economy Running Hot ... Chart 7... Will Eventually Produce Inflation Labor Market Indicators The first item on our list of labor-market indicators is the unemployment gap, the difference between the unemployment rate and NAIRU. NAIRU (the Non-Accelerating-Inflation Rate of Unemployment), is the estimate of the lowest sustainable unemployment rate. The actual rate fell below NAIRU in early 2017, and the gap has been getting steadily more negative ever since (Chart 8, top panel). A negative gap is associated with higher compensation, but the wage response has been muted so far (Chart 8, bottom panel). Chart 8Supply And Demand Friday's October employment report pointed to further downward pressure on the unemployment gap. The three-month moving average of net payroll additions came in at 218,000, keeping job growth for the last seven years at around 200,000/month (Chart 9). If the trend were to continue for another twelve months, and population growth and the labor force participation rate (Chart 10, middle panel) were to remain constant, the Atlanta Fed Jobs Calculator2 projects that the unemployment rate will fall to 3%. Chart 9A Steady, Job-Rich Recovery Chart 10As 'Hidden' Unemployment Shrinks ... We understand investors' impatience with the Phillips Curve. We admit to being surprised that compensation growth hasn't shown more life to this point (Chart 11). Just because wage gains have been sluggish out of the gate, however, doesn't mean they won't speed up in the future. Ancillary indicators like the broader definition of unemployment that includes discouraged and involuntary part-time workers (Chart 10, top panel), and the ratio of workers voluntarily leaving their jobs (Chart 10, bottom panel), reinforce the unemployment rate's signal that the labor market is on its way to becoming as tight as a drum. Chart 11... Wages Should Rise Broader Indications Of Instability The final three items on our checklist are meant to flag factors that could bump the Fed off its gradual rate-hiking pace. Overheating would encourage the Fed to move more quickly, but there is nothing in the main cyclical elements of the economy that stirs concern (Chart 12). The Fed might move faster if its third mandate - preserving financial stability - dictated it, but the Fed has been quiet about financial-sector imbalances since Governor Brainard expressed concern about corporate lending two months ago. Finally, the Fed is not oblivious to economic strain in the rest of the world, but conditions in even the most vulnerable emerging markets are far from triggering some sort of "EM put." Chart 12No Sign Of Overheating Yet Investment Implications We remain constructive on the economy and markets in the absence of a near-term catalyst to cut off the expansion, the credit cycle and/or the equity bull market. Like our bond strategists, we simply think the U.S. economy is too healthy to merit revising our bearish view on rates. The implication for investors with a balanced mandate is to continue to underweight Treasuries. Within fixed-income portfolios, investors should continue to maintain below-benchmark duration. No investment stance is forever, and we are counting on our checklist to help keep us alert to an approaching inflection point in rates, but the coast is clear for now. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?," published October 30, 2018. Available at usbs.bcaresearch.com. 2https://www.frbatlanta.org/chcs/calculator.aspx?panel=1

Highlights Investors are worrying too much about the things that caused the global financial crisis, and not enough about those that could cause the next downturn. Despite the recent patch of soft data, the U.S. housing market is in good shape. Go long homebuilders relative to the S&P 500. Imbalances in the corporate debt market have increased, but are not severe enough to generate systemic economic distress. U.S. rates will need to rise quite a bit more than the market anticipates before the economy slows by enough to force the Fed to back off. The combination of a stronger dollar and inadequate Chinese stimulus will continue to pressure emerging markets. Even Brazil's pro-capitalist new president may not be able to reverse the country's bleak fiscal dynamics. Our MacroQuant model, which predicted the correction, points to further near-term downside risk for global equities. The cyclical (12-to-18 month) outlook looks much better, however. Feature The Market's Maginot Line One of the most reliable ways to make money as an investor is to figure out the market's collective biases and trade against them. Behavioral economists have long noted that people tend to assign too much weight to recent experience in taking decisions. As a result, in finance, as in military strategy, there is a constant temptation to fight the last war. The last war policymakers waged was against the scourge of deflation that followed the housing bust and financial crisis. For much of the past decade, investors have held a magnifying glass over anything that could possibly resemble the conditions that led up to the Global Financial Crisis. While such behavior is understandable, it is misplaced. History suggests that both lenders and borrowers tend to act prudently for years, if not decades, following major financial crises. Mistakes are still made, but they are different mistakes. People overcompensate. They obsess about the past rather than focusing on the future. U.S. Housing Is Okay There is no denying that the U.S. housing market has softened this year (Chart 1). Housing starts, building permits, and home sales have all fallen. Residential investment has subtracted from GDP growth over three consecutive quarters. Chart 1Housing Has Been A Drag On The U.S. Economy This Year There is little mystery as to why the housing market has been on the back foot. The Trump tax bill capped the deduction on state and local property taxes, while reducing the amount of mortgage debt on which homeowners can deduct interest payments from $1 million to $750,000. This had a negative effect on housing activity, especially in high-tax Democrat-leaning states with elevated real estate prices. More importantly, mortgage rates have risen by over 100 basis points since last August. Chart 2 shows that home sales and construction almost always decline after mortgage rates rise. In this respect, the weakness in housing activity is reminiscent of the period following the taper tantrum, when housing activity also slowed sharply. Chart 2No Mystery Why U.S. Housing Has Been Weak... We do not expect mortgage rates to fall from current levels. But they are not going to rise at the same pace as they have over the past year. Thus, while the headwinds from higher financing costs will not disappear, they will abate to some extent. Fundamentally, the housing market is on solid ground (Chart 3). Mortgage rates are still well below their historic average. Home prices have risen considerably, but do not appear excessively stretched compared to rents or incomes. Unlike in 2006, the home vacancy rate is near its historic lows. Residential investment stands at only 3.9% of GDP, compared with a peak of 6.7% of GDP in the second half of 2005. The average age of the residential capital stock has risen by nearly five years since 2006, the largest increase since the Great Depression. With household formation rebounding briskly from its post-recession lows, homebuilders are still arguably not churning out enough new homes. Chart 3A...But Fundamentals Are Still In Good Shape (I) Chart 3B...But Fundamentals Are Still In Good Shape (II) Mortgage lenders have learned from past mistakes (Chart 4). While lending standards have eased modestly over the past 4 years, underwriting standards have remained high. The average FICO score for new borrowers is more than 40 points above pre-recession levels. The Urban Institute Housing Credit Availability index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is at reassuringly low levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. Moreover, banks today hold much more high-quality capital than in the past, which gives them additional space to absorb losses (Chart 5). Chart 4Lending Standards Have Been Tight, But Are Starting To Loosen Chart 5U.S. Banks Are Well Capitalized With all this in mind, we are initiating a new strategic trade to go long U.S. homebuilders relative to the S&P 500.1 Corporate Debt: How Big Are The Risks? Unlike household debt, U.S. corporate debt has risen over the past decade and now stands at a record high level as a share of GDP. The quality of the lending has also been less than pristine, as evidenced by the proliferation of "covenant lite" loans. The interest coverage ratio for the economy as a whole - defined as the volume of profits corporations generate for every dollar of interest paid - is still above its historic average (Chart 6). However, this number is skewed by a few mega-cap tech companies that hold a lot of cash and have little debt. Chart 6Interest Coverage Looks Relatively High My colleague Mark McClellan, who writes our monthly Bank Credit Analyst publication, has shown that the interest coverage ratio for companies comprising the Bloomberg Barclays index would drop close to the lows of the Great Recession if interest rates were to rise by a mere 100 basis points across the corporate curve. The damage would be far worse if profits also fell by 25% in this scenario.2 While the corporate debt market has become increasingly frothy, it does not pose an imminent danger to the economy. There are several reasons for this. First, while U.S. corporate debt is high in relation to the past, it is still quite low in comparison with many other economies (Chart 7). The ratio of corporate debt-to-GDP, for example, is 30 percentage points higher in the euro area. This suggests that U.S. businesses still have the "carrying capacity" to take on additional debt. Chart 7U.S. Corporate Debt Is Not That High By Global Standards Second, the average maturity of U.S. corporate debt has risen over the past decade, with an increasing share of companies opting for fixed over floating-rate borrowings. This implies that it will take a while for the effect of higher rates to make their way through the system. Third, and perhaps most importantly, corporate bonds are generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. Bank loans account for only 18% of nonfinancial corporate-sector debt, down from 40% in 1980 (Chart 8). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Chart 8Banks Have Reduced Their Exposure To The Corporate Sector Tellingly, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal (Chart 9). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 9The 2015 Debt Scare Did Not Topple The Economy Government Debt: No Worries... Yet If the risks posed by both the housing market and corporate debt market are contained, what about the risks posed by soaring government debt? The long-term fiscal outlook is certainly bleak, but the near-term risks are low.3 President Trump's tweets aside, the U.S. has an independent central bank which has been able to keep inflation expectations well anchored. The U.S. private sector is also running a financial surplus at the moment, meaning that it earns more than it spends (Chart 10). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its fiscal deficit. Chart 10The U.S. Private Sector Is A Net Saver The private sector's financial balance will deteriorate over the next two years as household savings decline and corporate investment rises. This will put upward pressure on Treasury yields. However, if rising yields are reflective of stronger aggregate demand, this is unlikely to derail the economy. When Things Break Recessions are usually caused when the Fed raises rates by enough to undermine spending on interest rate-sensitive purchases such as housing, or when higher rates prick an asset bubble just waiting to burst. Given the lack of clear imbalances either in the real economy or financial markets, the Fed may have to raise rates significantly more than the market is currently anticipating. In fact, far from having to press the pause button midway through next year, our baseline expectation is that the Fed will expedite the pace of rate hikes in late 2019 as inflation finally starts to accelerate. Aggressive Fed rate hikes combined with an incrementally less expansionary fiscal policy will sow the seeds of a recession in late 2020 or 2021. Before the next U.S. downturn arrives, the dollar will have strengthened further. A resurgent greenback will cast a long shadow over emerging markets and commodity producers. As we discussed last week, China is unlikely to save the day by launching a massive stimulus program of the sort that it orchestrated in both 2009 and 2015.4 True, not all emerging markets are equal. Emerging Asia is more resilient now than it was two decades ago. Thailand, for example, was patient zero for the Asian crisis in 1997. Today, it sports a current account surplus of over 10% of GDP and low levels of external debt. This resilience will not prevent Asian economies from experiencing slower growth on the back of weaker Chinese demand, but it will prevent a full-blown balance of payments crisis from spiraling out of control. In contrast to Emerging Asia, Latin America looks more vulnerable (Table 1). BCA's chief emerging market strategist, Arthur Budaghyan, wisely upgraded Brazilian assets on a tactical basis on October 9th ahead of the presidential elections. Nevertheless, Arthur still worries that Brazil's daunting fiscal challenges - the budget deficit currently stands at 7.8% of GDP and the IMF expects government debt to rise to nearly 100% of GDP over the next five years (Chart 11) - are so grave that even South America's answer to Donald Trump may not be able to save the Brazilian economy. Table 1Vulnerability Heat Map For Key EM Markets Chart 11Brazil Is Fiscally Challenged A Correction, Not A Bear Market The current market environment bears some similarities to the late 1990s. The Fed is tightening monetary policy in order to keep the domestic economy from overheating. The U.S. economy is responding to higher rates to some extent, but the main effects are being felt overseas. The Asian Crisis did not end the bull market in U.S. stocks, but it did generate a few nasty selloffs, the most notable being the 22% peak-to-trough decline in the S&P 500 between July 20 and October 8, 1998. We witnessed such a selloff this October. The bad news is that our MacroQuant model is pointing to additional equity weakness over the coming weeks (Chart 12). The model tends to downgrade stocks whenever growth is slipping, financial conditions are tightening, and sentiment is deteriorating from bullish levels. All three of these things are currently occurring. Chart 12MacroQuant* Model Suggests Caution Is Warranted The good news is that none of our recession indicators are flashing red. Since recessions and bear markets typically overlap (Chart 13), the odds are high that the current stock market correction will be just that, a correction. Chart 13Recessions And Bear Markets Usually Overlap Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The corresponding ETFs are long ITB/short SPY. 2 Please see The Bank Credit Analyst Special Report, "The Long Shadow Of The Financial Crisis," dated October 25, 2018. 3 It is actually not even clear that a loss of confidence in America's fiscal management would cause a recession. The Fed largely determines borrowing costs at the short-to-medium end of the yield curve, which is where the government finances most of its debt. If people lose confidence in the dollar, they will either need to run down their cash balances by purchasing more goods and services or try to move their wealth abroad. The former will directly increase aggregate demand, while the latter will indirectly increase it through a weaker currency. To be clear, we are not suggesting that such an outcome would be beneficial to the economy; it would, among other things, greatly slow potential GDP growth by discouraging investment. But the near-term effect would likely be economic overheating and rising inflation rather than a recession. 4 Please see Global Investment Strategy Weekly Report, "Chinese Stimulus: Not So Stimulating," dated October 26, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights Investors looking for equity upside, along with fixed-income-like downside protection, coupled with a hedge against rising rates, should consider convertible bonds. As we near the end of the business cycle, the attractions of convertibles are becoming clearer: investors will benefit from more upside capture in case of a last run-up in stocks, but at the same time suffer less downside in a recession. Moreover, in periods of rising rates, convertible bonds perform well compared to other traditional fixed-income securities. However, multi-asset portfolio managers should note that the risk-return profile of convertible bonds is more like equities than bonds, and so convertibles have no place in a conservative fixed-income portfolio. Investors have a number of options to choose from when customizing equity-versus-fixed-income exposure in their convertible allocations. Feature Introduction An ideal financial instrument would have large equity exposure in an equity bull market, and increased fixed-income exposure in a bear market. Financial engineering can create synthetic positions using derivatives to replicate just this sort of hybrid exposure - or an investor can just buy convertible bonds. In this current, late, phase of the business cycle - with increased volatility, rising interest rates, and a pickup in inflation - where can investors find shelter, but without sacrificing returns in the event of a last blow-out run-up in stocks? In this report, we discuss how convertible bonds - despite their somewhat complex structure1 - could be the answer. Issuers prefer convertibles to traditional corporate bonds because of: 1) a lower coupon rate and fewer covenants, 2) the opportunity to sell equity at a premium to the current price, 3) a faster process for raising capital, compared to a secondary equity issue, and 4) easier access to capital markets for non-investment grade firms. On the demand side, the composition of convertible investors has evolved over time. Prior to the 2007-9 Global Financial Crisis (GFC), proprietary trading desks and leveraged hedge funds were the most important players, since convertible arbitrage2 was very profitable. But the liquidity freeze in 2008 and 2009 forced these short-term investors out of the market and brought back long-term buy-and-hold investors. Currently 65% of U.S. convertible bonds are held by long-only investors. This change in market structure has had important implications for arbitrage opportunities (Chart 1). Chart 1Fewer Short-Term Investors In the first half of 2018, issuance of global convertible securities topped $57 billion, the largest amount for a six-month period since 2008. The U.S. led the way, with issuance of $34 billion (Chart 2), followed by Asia ex-Japan at $12 billion, and Europe, $10 billion. The U.S. total includes $13.4 billion in convertible bond issuance by tech companies, the highest amount in the post-GFC period (Chart 2, panel 2). Bank of America Merrill Lynch estimates that full-year global issuance could be the highest in 12 years. The macro-backdrop for convertibles remains favorable: Chart 2Issuance Similar To Pre-Crisis Levels The hybrid equity/fixed-income exposure offers protection against rising rates because of its shorter duration; The new U.S. tax code limits interest deductibility, which strengthens the relative appeal of issuing a convertible security instead of a traditional bond; The return of volatility means investors benefit from holding a security with an embedded option; The flexibility of the asset class gives investors room to customize their exposure in terms of coupon rate, premium, and maturity. In this report, we start with the market structure and mechanics of convertible bonds. Next, we look at the four types of convertible bonds, which provide different risk-return profiles. In the following section, we analyze historical returns and performance in different market environments. Finally, we discuss the key asset allocation decisions involved in investing in convertible bonds. Our main findings are: Investors can customize their risk-return profile by choosing between high-volatility equity exposure (equity-sensitive convertibles), or more stable fixed-income exposure (credit-sensitive convertibles); Convertible bonds historically have generated an annualized return of 9.5% compared to 9.8% from equities, but with 2% lower volatility; Convertible bonds have a risk-return profile more like that of equities and junk bonds than that of investment-grade credit; In periods of rising rates and inflation, convertible bonds have outperformed their traditional fixed-income counterparts; In comparison to equities, convertibles capture more upside in bull markets than downside in bear markets; Investing in convertible bonds requires active management because of their varying degree of equity- and fixed-income sensitivity that changes over time. The Convertibles Market Convertible securities can be broken into three key groups: 1) convertible bonds (cash-pay3 and zero-coupon), 2) convertible preferred shares, and 3) mandatory convertibles. Cash-pay convertible bonds make up almost 80% of the outstanding market (Chart 3), while zero-coupon convertible bonds are almost non-existent. Mandatories and convertible preferred equities make up 15% and 7% respectively. Chart 3Convertibles Bonds Are 80% Of Convertibles Market... Before we delve deeper into the convertible bond markets, here are few key characteristics (Chart 4) of the other two groups: Chart 4...And Have The Best Risk-Adjusted Returns Convertible Preferred Equities are issued with a specific dividend rate that is generally higher than the dividend on common shares. They include an embedded option to convert to a specified number of common shares. Additionally, preferred dividends usually accumulate in arrears should the firm be unable to make a payment. The conversion rate increases with any increase in the common-share dividend. After the call protection expires, the company has the option of redeeming the issue at the stated par value. Mandatory Convertibles. These bonds automatically convert to common shares at a specified time. However, they do not offer downside protection since conversion can be into shares worth less than the original issue price. Rating agencies view these securities more as equities than bonds, giving firms an incentive to issue them from a balance-sheet perspective. Table 1 shows us that cash-pay (coupon paying convertible bonds) generated the highest return with the lowest volatility, thereby providing investors with the best risk-adjusted returns. Mandatory convertibles have a large excess kurtosis - driven by the forced conversion into equities at inopportune times. In bull and bear markets, it is clear convertible bonds did not enjoy the full upside provided by preferred shares and mandatories, but had 50% less downside in bear markets. Also, in periods of rising rates convertible bonds produced positive returns, but lagged both preferred shares and mandatory convertibles. Table 1Convertible Bonds' Risk-Return Profile A niche market exists for contingent convertibles (CoCos) - or, as they are sometimes called, anti-convertibles. Banks in the euro area issue CoCos to meet capital requirements and provide a cushion should they find themselves in a serious predicament. These typically pay a higher coupon than the bank's straight bonds to compensate for the possibility of a complete wipeout. In short, if all goes well you receive your fixed coupons and principal back at maturity. But, if things turn sour, the bonds convert to equity and the investor potentially loses everything. Mechanics Of Convertible Bonds Convertible bonds are a hybrid security issued as a senior unsecured bond with a fixed maturity (normally five years) with optionality to convert to a fixed number of shares. In exchange for the equity kicker, these bonds typically yield less and carry a lower coupon rate (Chart 5) than the issuer's comparable non-convertible debt. We describe the basics of convertible bonds in the Appendix. Chart 5The Cost Of An Embedded Option An investor considering an allocation to convertibles has four groups to choose from depending on his or her risk-return tolerance. The trade-off is between high volatility equity exposure versus more stable credit exposure. If the underlying stock does well, the convertible increases in value even without the investor exercising the option to convert into shares. If the stock does not appreciate, the investor retains the bond and collects regular coupons and par value at maturity. The interaction of market price with investment value and conversion price creates convertible bonds with different risk-return profiles: Credit Sensitive: A large decrease in the stock price has pushed the convertibles to trade close to their investment value (bond floor). These are out-of-the money convertibles, with a delta ranging from 10% to 40%, and also with large premium over investment value. The main factors affecting the pricing of such instruments are the level of interest rates and credit spreads. An investor has a small probability of generating large unexpected gains from underlying stock appreciation. Balanced: The stock price is close to the conversion price, making these at-the-money convertibles. They have a moderate premium to conversion value, and deltas in the range of 40-80%. Rising stock prices make the embedded call option more valuable, pushing the convertible price closer to the stock price. Long-term buy-and-hold investors looking to maintain a core allocation to convertibles should invest in balanced convertibles. Equity Sensitive: Convertibles that are deep in-the-money, trading near parity, with high deltas of over 80%, and generating returns that closely track equities. They still retain some downside protection due to seniority and par value at maturity even if they have most of the common share's upside potential. Distressed: As a company threatens to default or goes bankrupt, the value of the straight bond component declines to trade significantly below par. These bonds tend to have high degree of price volatility and low probability of return of capital. Risk & Return Convertible bond returns are driven by: 1) the bond component that is a function of rates, credit spreads, and curve effects; 2) the equity component, supported by the delta to the underlying stock price; and 3) the option component, that is a function of the underlying stock price and time to maturity. Convertibles combine characteristics of stocks and bonds (Chart 6), so they represent either lower-volatility equity exposure or enhanced fixed-income exposure. Over the past 24 years (Table 2), U.S. convertible bonds generated returns similar to U.S. equities, but with a lower volatility. However, relative to traditional corporate bonds, convertibles outperformed massively, but with much higher volatility. Looking at risk-adjusted returns, we see that convertible bonds have more similarity to equities and high-yield credit than to investment-grade credit (Chart 7). However, defaults in the convertible bond space have been close to 1%, which is significantly lower than the 4% in the high-yield credit market (Chart 8). This is because convertible bonds include a smaller proportion of issuers with high operating leverage, such as energy producers, and have a high representation of mature healthcare and technology companies. Chart 6Convertibles Vs. Traditional Table 2Better Than Equities, But More Volatile Than Traditional Bonds Chart 7Close To Equities & Junk Chart 8Lower Defaults Than Junk Bonds Short-term performance of the convertible bond market is driven by the composition of issuers, but long-term performance is driven by the performance of the different variables described above. In 1Q 2018, convertible bonds outperformed equities, largely due to technology and consumer staples convertibles. Technology convertibles saw a 11% gain, while the S&P technology sector was up only 3.5%. This was because technology convertible issuers were concentrated in the mid-cap growth segment, whereas the large-cap equity names are more heavily weighted in semiconductors. BCA has for two or three years been warning about the return of inflation and rising interest rates. Convertible bonds outperform traditional fixed income in periods of rising interest rates because: 1) rising rates are often coupled with periods of positive equity momentum, which benefits convertibles; 2) convertibles have lower duration than straight bonds. Since 1994, there have been 10 instances when the 10-year U.S. Treasury yield rose by more than 100 bps: convertible bonds outperformed in every instance. Additionally, convertible bonds enjoy a yield advantage: the average income return (coupon rate) on a convertible is greater than the dividend yield on the underlying stock. When investors allocate to convertible bonds from either their equity or fixed-income portfolio, the key consideration is upside versus downside exposure. When the underlying stock price rises, convertibles will capture a portion of the capital appreciation but, on the downside, convertibles continue to provide a consistent income flow and principal repayment at maturity. History tells us that convertibles capture more upside in bull markets than downside in bear markets. If the share price falls sharply below the conversion price, the convertible will react less and less to fluctuations in the underlying stock price. In short, convertible bonds provide more downside protection than stocks as market value will not drop below the investment value (bond floor). Convertibles also have a mechanism to offset rising equity volatility and rising rates. The embedded equity option in a convertible bond rises in value when volatility rises, providing a meaningful offset in contrast to equities that may suffer a drawdown. Over the long-run, convexity enables this asset to make the most of favorable stock market conditions, whilst suffering less in difficult conditions. As mentioned earlier, the risk-return profile of convertible bonds tends to have a closer relation with equities than with fixed income. Within fixed income, high-yield credit, which tends to have a return profile closely aligned with equities, has a strong correlation with convertible bonds. The greatest diversification potential is when convertible bonds are added to a portfolio of government bonds. However, investors should realize the risk-return profiles for convertibles and government bonds are very different, and an allocation to the former is only a possibility for an investor with a higher risk tolerance. What To Choose From? Equity Sensitive Versus Credit Sensitive Investors need to choose the right type of convertible bond depending on their risk tolerance. Equity-sensitive convertibles made up over 60% of the market prior to the GFC, but this proportion fell to around 20% during the recession (Chart 9). As stock prices tumble, the market price of convertibles get closer to the investment value (bond floor), and convertibles start behaving more like pure credit-sensitive bonds. Looking at total returns (Chart 10 & Table 3), it is clear that aggressive investors with a higher risk tolerance should invest exclusively in equity-sensitive convertibles. But investors looking to maintain a core long-term allocation to convertibles should focus on the balanced group. Despite being a small piece of the market, distressed convertibles are attractive return enhancers immediately after a recession. Investors looking for income return should prefer credit-sensitive or distressed convertibles over equity-sensitive ones. Equity-sensitive convertibles have the highest delta, making them the most vulnerable to underperformance in a downturn. Balanced convertibles have the highest vega, which means they are most impacted by increasing volatility - driven by both equity and rate volatility. In times of rising interest rates, equity-sensitive convertibles provide their best protection given their short duration. Credit- and rate-sensitive convertibles have almost double the duration, making them more vulnerable to rising rates. Chart 9Equity Vs. Fixed Income Exposure Chart 10Massive Outperformance By Equity Sensitive Table 3Equity Sensitive For The Aggressive, Credit Sensitive For The Conservative, Balanced For Everyone Small Cap Versus Large Cap Issues Investors can choose between convertible issues from companies of different size. Since the middle of the financial crisis, large-cap issues have grown to over 50% of the market (Chart 11), up from below 30%. The increase in market share was taken from small-cap issues, with mid-cap issues stable at 20% of the market. In terms of total returns (Chart 12 & Table 4), small cap outperformed both mid and, particularly, large caps. Part of this outperformance was due to the higher yield offered by small-cap issuers compared to their larger counterparts. In terms of equity sensitivity, small-cap issues currently have significantly lower delta than large caps. However, in times of rising volatility, small-cap issues lose more, driven by their higher vega. In terms of interest-rate sensitivity, all three sizes are roughly equally exposed given similar durations. Chart 11Bigger Is Not Always Better Chart 12Small Cap Outperforms Table 4Small Cap Provides The Best Value Investment Grade Versus The Rest A credit investor has one particularly important call: investment-grade versus high-yield. The situation is trickier for convertibles as over 60% of the bonds are unrated (Chart 13), thereby giving managers amply opportunity for alpha generation. Historical performance (Chart 14 & Table 5) shows that non-rated convertible bonds have a close relationship with non-investment-grade issues. Moreover, the relative performance of non-investment-grade and non-rated issues with investment grade issues follows a similar path. From an income-return perspective, both non-rated and non-investment-grade issues have lost their yield advantage since 2016. Investors are not receiving adequate yield for the additional risk they are taking with riskier issues. The return of volatility will have a smaller impact on investment-grade issues compared to the rest of the market because the former have a lower effective duration. Additionally, implied volatility is lower for investment-grade issues. Chart 13Over 60% Has No Credit Rating Chart 14Similar Return, But Different Risk Table 5No Rating = Source Of Alpha The Asset Allocation Decision The key question here is: are investors looking at convertible bonds (Chart 15) as part of an equity or a fixed-income allocation? Investors considering convertibles as part of their equity allocation are looking for a more defensive exposure and yield pick-up, and so should focus on balanced convertibles and not equity-sensitive ones. On the other hand, considering convertibles as part of fixed-income allocation will deliver equity exposure, and so investors should focus on credit-sensitive or balanced convertibles. Chart 15Somewhere Between Equities & Junk Another major factor is the investment horizon of the convertible allocation. A core strategic allocation to convertibles will require a hybrid exposure, providing lower-volatility equity exposure over multiple full market cycles. Such investors are looking for long-term equity upside, but are concerned about shorter-term downside equity volatility and should consider balanced convertibles. On the other hand, investors using convertibles as part of a tactical allocation, to make a short-term bet in order to diversify away from traditional fixed-income or equity exposure, should consider either equity-sensitive or credit-sensitive convertibles. The bottom-line is that convertible investing requires active management because these securities have varying degrees of equity and fixed-income sensitivity that change over time. In periods of rising equity markets, an investor with passive exposure to convertibles would automatically have a large holding in equity-sensitive convertibles with a high delta, thereby increasing his or her exposure to equity downside risk. For example, in February 2009, when markets troughed after the GFC, more than two-thirds of convertibles were trading as credit-sensitive instruments. An investor following a passive index in this situation would have had minimal exposure to equity-sensitive convertibles, and would thereby have had limited participation in the equity upside. Finally, the convertible universe is constantly evolving. The typical convertible bond is issued with a five-year life by a company in the early to mid stage of its corporate life cycle, seeking capital to grow. As time passes, the issuer matures to a point where it no longer needs convertibles in its capital structure. Nearly two-thirds of the current issuers of convertible were not in the market 10 years ago, while two-thirds of the S&P 500 members remain unchanged over this time. Aditya Kurian, Senior Analyst Global Asset Allocation adityak@bcaresearch.com 1 Despite the complexities, the first convertible bond was issued as long ago as 1874 by Rome, Watertown and Ogdensburg Railroad to finance a project. The bond was never converted since the underlying shares failed to rise enough and the company refinanced the bond in 1904. 2 For an explanation of convertible arbitrage, please see A Note On Convertible Arbitrage at the end of this report. 3 Convertible bonds that make regular coupon payments. A Note On Convertible Arbitrage A market-neutral hedge fund strategy where the manager goes long the convertible bond and short the underlying stock. The short position in the underlying stock creates a delta-neutral position, but maintaining this position requires dynamic hedging which is expensive. There is a possibility of large mispricing because of the over-the-counter nature of the market and uncertainty regarding call or redemption features of convertibles. Often, the embedded equity option is a source of cheap volatility compared to the underlying stock's listed options. A quick measure for convertible valuations is comparing the volatility of options in the market to the volatility priced in the embedded option in the convertible. If market volatility rises, but the price of convertible stays the same, the security could be cheap and attractive. Looking at historical performance (Table 6), convertible arbitrage generated almost 3% less than equities, but with less than half the volatility. However, all of the outperformance was during recessions or equity bear markets. Additionally, convertible arbitrage funds have large negative skew and kurtosis relative to both equities and the hedge-fund composite. We recommend investors allocate to convertible arbitrage hedge funds in preparation for a downturn. Table 6Convertible Arbitrage Versus Traditionals Appendix: The Basics Of Convertible Bonds Investment Value (Bond Floor): The fixed-income component of the convertible bond, or in other words, the value of the bond without the conversion feature (equity kicker). This remains stable over a wide range of stock prices but, when creditworthiness deteriorates, consequent stock price movements will have an impact on the investment value (IV). Holding creditworthiness constant, the IV provides the bond floor, below which the convertible should not trade. The IV fluctuates in tandem with the price of a straight corporate bond of similar quality. A convertible that is trading close to its IV will be more affected by changes in rates than one that is well above it. Investment Premium: The market price minus IV expressed as a percentage of IV. Premium over IV indicates the level of downside risk. A higher premium means the bond price is more sensitive to the price of underlying stock, which means less downside protection because the bond market price would have to decline significantly before reaching the IV. Higher premium is a result of rising underlying stock value, whereas a smaller premium is when the convertible is more interest-rate sensitive and behaves like a pure bond. Conversion Value (CV): The equity portion of the convertible bond. Conversion ratio is set at the time of issuance and it is the number of shares a bondholder will receive upon conversion. Conversion price is the price at which the number of converted shares is equal to the par value of the bond. At issuance, the underlying stock price is usually below conversion price. Conversion Premium: The market price minus CV expressed as a percentage of CV. As market price rises above CV, fixed-income attributes are lost and equity features take over, consequently decreasing conversion premium. Declining stock prices mean convertible market price approaches fixed-income value (bond floor) and conversion premium increases. Appendix Chart 1Preferred Shares & Mandatory Convertibles Have Higher Income Returns Appendix Chart 2Convertible Bonds' Delta & Vega Reduces In A Recession Appendix Chart 3Conversion Premium Far From Recessionary Levels Appendix Chart 4Average Duration Less Than 2.5 Appendix Chart 5U.S. Is 60% Of Global Appendix Chart 6U.S. Is Clearly The Best Performer Appendix Chart 7U.S. Also Provides The Best Income Return Appendix Chart 8But, U.S. Is The Most Equity Sensitive Appendix Chart 9U.S. Has A Higher Implied Volatility Appendix Chart 10Distressed Is The Best Solution Immediately After A Recession Appendix Chart 11Balanced Has The Lowest Coupon Appendix Chart 12Balanced Has Moderate Delta, But Highest Vega Appendix Chart 13Equity Sensitive Are The Best Rate Hedge Appendix Chart 14Premiums Are Stable Appendix Chart 15Mid-Cap Provides Low Income Return Appendix Chart 16Massive Delta & Vega Divergence Appendix Chart 17Large Cap Premium Has Risen The Most Appendix Chart 18Implied Volatility Is Similar Across The Board Appendix Chart 19ALl Coupon Rates Have Fallen Appendix Chart 20Investment Grade Has The Highest Delta Appendix Chart 21Underweight Duration = Investment Grade Convertibles Appendix Chart 22Premiums Stable

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of October 31, 2018. The quant model downgraded U.S. and Italy to underweight from overweight while upgrading Canada to a slight overweight from underweight, largely due to changes in technical and valuation conditions. Now the model is overweight 5 countries (Netherland, Germany, Spain, Switzerland and Canada) and underweight 7 countries (Japan, U.S., U.K., France, Australia, Sweden and Italy), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, both Level 1 and Level 2 of the model system outperformed in October by 6bps and 57 bps, respectively, resulting in an outperformance of 24 bps from the overall model. Since going live, the overall model has outperformed its benchmarks by 44 bps, driven by Level 2 outperformance of 121 bps and Level 1 outperformance of 2bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, "Global Equity Allocation: Introducing The Developed Markets Country Allocation Model," dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, As advised last month, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understand will be in December. We thank you for your understanding.

Dear Client, You will see in this Monthly Portfolio Update that we have expanded our table of Recommendations to include a wider range of the views that Global Asset Allocation (GAA) regularly discusses in its publications. Please see our most recent Quarterly Portfolio Outlook1 for a detailed explanation of those recommendations that we do not specifically touch on in this Monthly. A note on our publication schedule. We will not publish a Monthly for December, or a Q1 2019 Quarterly in mid-December. Instead, we will send you in late November the BCA 2019 Outlook (BCA's annual discussion with Mr. and Ms. X). This will be accompanied by a short GAA note, updating our recommendation tables with a brief commentary. Best Regards, Garry Evans A Correction, Not A Bear Market Investors have a tendency to forget that corrections are common in bull markets. The current equity run-up, which began in March 2009, has seen five corrections (defined as a 10-20% decline in the S&P500). We may now be experiencing the sixth, with the index already down 9.9% from its peak on September 20. Recommendations But we think the evidence is fairly strong that this is just a correction and not the beginning of a new bear market (using the common definition of a 20% or greater fall). It is highly unusual for bear markets to occur - and for bonds to outperform equities - except in the run-up to, and during, recessions (Chart 1). We see little to suggest that a recession in on the horizon over the next 12 months. Chart 1Corrections Are Not At All Rare What caused the correction? The immediate trigger was a seemingly concerted series of statements in early October from FOMC officials, including even doves such as Lael Brainard, that economic circumstances are "remarkably positive" and that rates remain "a long way from neutral" (to quote Fed Chair Jay Powell). In particular, New York Fed President John Williams argued that the neutral rate of interest (the r*) is very uncertain - even though he was joint creator of the main model that estimates it. The implication is that the Fed will keep on raising rates until the economy clearly slows. This pushed the 10-year Treasury yield above 3.2%. Markets are starting to worry that the Fed will make a policy mistake and that certain segments of the economy (housing, emerging markets?) may be too weak to withstand tighter monetary policy. Moreover, this is in a context in which global growth has been weakening (Chart 2), China appears to be slowing quite sharply (Chart 3), the trade war is escalating (with the U.S. now threatening to impose tariffs on all Chinese imports), and valuations for most assets are stretched. Chart 2Outside The U.S., Growth Is Slowing Chart 3Sharp Slowdown Ahead For China? So how worried should investors be? Most of the usual indicators of generalized risk aversion have not flashed strong warning signals during the equity market sell-off (Chart 4). The move up in bond yields came mostly from a rise in real yields, not inflation expectations, and the yield curve steepened, suggesting that markets are pricing in stronger growth not excessive Fed action. Safe haven assets, such as gold and the Swiss franc, did not perform particularly strongly. Credit spreads rose a little, by around 70 basis points, but do not yet signal stress. Chart 4No Signals Of Strong Risk Aversion Moreover U.S. growth, in particular, remains robust. Though the r* may be tricky to estimate, monetary policy is still clearly accommodative and is likely to remain so until at least mid-2019, even if the Fed hikes by 25bp a quarter (Chart 5). Fiscal policy will be stimulative until the end of 2019, adding 1.1 percentage points to growth this year and 0.5 next, according to IMF estimates. Earnings growth will slow from its current lick - Q3 U.S. earnings look like coming in at 23% year-on-year, compared to a forecast of 19% before the results season - but our models suggest that 2019 bottom-up estimates are about right, with growth slowing to around 10% in the U.S. and to somewhat less in the euro area and Japan (Chart 6).2 Chart 5Fed Policy Still Accomodative Chart 6Earnings Growth To Continue, Albeit More Slowly If we have a concern, it is that a few interest-rate sensitive elements of the U.S. economy are showing signs of softness. Housing starts have been weak for a while, but higher mortgage rates may now be having an effect, with residential investment subtracting from GDP growth in all three quarters so far this year (Chart 7). However, mortgage rates are unlikely to continue to rise at the same pace and so the effect should weaken in further quarters. Capex intentions and durable orders have also slipped, perhaps suggesting that corporations have reined back investment plans due to global uncertainties (Chart 8). But these signs point to slower growth next year, not recession, with the U.S. likely to continue to grow above trend. Historically, higher long-term rates have proved a drag on the economy only when they have risen above trend nominal GDP growth, currently around 3.8% (Chart 9). We have some way to go before we reach that tipping-point. Chart 7Housing Is Hurting Chart 8...And Capex Is Getting Cautious Chart 9Rates Matter When They Exceed Nominal Growth We moved to neutral on risk assets, including equities, at the beginning of July. Many of the worries we flagged then have come about. This is late in the cycle, and so volatility will probably remain elevated. However, we do not expect the next recession to come until 2020 at the earliest. Moreover, none of the warning signals on our bear market checklist (which includes the shape of the yield curve, profit margins, a peak in cyclical spending as a percentage of GDP, Fed policy becoming restrictive etc.) are yet flashing, though several may do by mid next year. Equity market valuations are no longer expensive after the recent sell-off (Chart 10). If the current correction were to continue and the drop in the S&P 500 extend to 15% and in global equities to 20% from their most recent peaks, we might be inclined tactically to move back overweight on risk assets. Chart 10Stocks Are No Longer Expensive Currencies: We expect further U.S. dollar appreciation. Divergences in growth and monetary policy between the U.S. and other developed markets will continue. While we expect the Fed to continue to hike once a quarter until end-2019, we could imagine the ECB turning more dovish if euro zone growth continues to slow and Italian BTP 10-year bond yields rise above 4%. The Bank of Japan will stick to its Yield Curve Control policy, which will prevent the yen rising. Emerging market currencies look vulnerable as their economies slow as a result of central bank rate hikes earlier in the year. Asian currencies might undertake competitive devaluations if the renminbi falls below 7, as a result of a worsening trade war. Fixed Income: Long-term rates are unlikely to have peaked for this cycle. Core inflation will stay at around 2% for a few more months because of a favorable base effect, but underlying inflation pressures (the result of rising wages and increases in import tariffs) will push up U.S. inflation by mid next year (Chart 11). A combination of higher inflation, steady Fed hikes, and deteriorating supply/demand conditions (which will raise the term premium) will move 10-year rates above 3.5% by mid-2019 (Chart 12). We accordingly recommend being short duration and overweight TIPs. U.S. high-yield bonds look somewhat attractive, with a default-adjusted spread of 270 bps, after their recent modest sell-off (Chart 13). But this is dependent on our assumption (based on Moody's model) of credit defaults of only 1.04% over the next 12 months.3 Given where we are in the cycle, and considering the elevated corporate leverage in the U.S., we do not consider this a risk worth taking, and so maintain our moderate underweight in credit. Chart 11Underlying Inflation Pressures Are Strong Chart 12Indicators Point To Treasury Yields Above 3.5% Chart 13Are Junk Bonds Attractive Again? Equities: We prefer DM equities over EM, and favor the U.S. and, to a degree, Japan. Emerging markets continue their deleveraging process and will be hurt by rising U.S. rates, a stronger dollar, and slowdown in China. Valuations for EM equities, though one standard deviation cheap relative to global equities, are not yet sufficiently attractively valued to permit investors to buy EM stocks irrespective of their poor fundamentals. Moreover, analysts are still far too optimistic on the outlook for EM earnings, flattering the valuation metric (Chart 14). Stronger growth and an appreciating currency point to an overweight in U.S. equities which, moreover, would be likely to outperform in the event of a deeper correction, given their low beta. Chart 14EM Equities Aren't As Cheap As They Seem Commodities: The crude oil price has fallen back a little in recent weeks, as a result of increases in OPEC production, a modest slowing of demand, and releases of the U.S. Strategic Petroleum Reserve. Our energy strategists have slightly lowered their 2019 Brent forecast to $92 a barrel, from $95 (Chart 15). However, they warn that geopolitical risks, such as widespread application of sanctions on Iran and a collapse in Venezuela, and limits to capacity in Saudi Arabia and U.S. shale production could easily cause spikes above $100.4 A 100% year-on-year rise in oil prices has historically been a clear warning of recession. That would equal Brent at $120 in 1H 2019. Metal prices will continue to be driven by China. At the moment we see no sign of China implementing a major stimulus, which would boost infrastructure spending and therefore demand for commodities (Chart 16), and so we expect further falls in industrial commodities prices. Chart 15Oil Prices Can Rise Further Chart 16No Sings Of Big China Stimilus Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see GAA Quarterly Portfolio Outlook - October 2018, available at gaa.bcaresearch.com 2 For details of these models and the assumptions behind them, please see The Bank Credit Analyst November 2018, available at bca.bcaresearch.com 3 For details please see BCA U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 4 For details please see BCA Commodity & Energy Strategy & Bond Strategy Weekly Report, "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity", dated October 25, 2018, available at ces.bcaresearch.com GAA Asset Allocation

Highlights In the Philippines, inflation is breaking out while the central bank is well behind the curve. Financials markets remain at risk. As a play on surging interest rates: Go short Philippine property stocks. We appraise and modify our investment strategy across all central European markets in general and Hungary in particular - where a monetary policy shift is in the making. A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area. Feature The Philippines: Short Real Estate Stocks Philippine stocks are on the verge of a major breakdown (Chart I-1, top panel). Meanwhile, local currency bond yields are surging (Chart I-1, bottom panel). Chart I-1Philippine Stocks Are On The Edge Of A Breakdown The Philippine economy continues to overheat, and the Bangko Sentral ng Pilipinas (BSP) has fallen well behind the curve. The top panel of Chart I-2 shows that both headline and core inflation measures are rising precipitously and have breached the central bank's upper target of 4% by a wide margin. Chart I-2The Central Bank Is Far Behind The Curve Odds are that inflation will continue to climb higher. Overall domestic demand remains reasonably strong. Noticeably, both the current and fiscal accounts are in deficit and widening (Chart I-3). A current account deficit is a form of hidden inflation. The basis is that it gauges the degree of excess domestic demand relative to the productive capacity of the economy. Chart I-3The Philippines: A Large Twin Deficit The roots of these macro problems stem from ultra-easy monetary and fiscal policies pursued by Filipino authorities. The BSP has kept borrowing costs low and for much longer than was warranted, and has been slow to hike rates. As a result, credit has been booming relentlessly (Chart I-4). Chart I-4Bank Loans Have Boomed... The fiscal authorities, on the other hand, have vigorously pursued growth-at-all-costs programs. Government spending is now growing at an annual rate of 22% (Chart I-5). Chart I-5...So Have Government Expenditures Consequently, these populist policies have created excessive domestic demand that has stoked an inflation breakout. Given Philippine President Rodrigo Duterte's reluctance to cut back on fiscal expenditures, it will be up to the monetary authorities to tighten sufficiently enough to curb inflation.1 The currency was depreciating against the U.S. dollar in 2017, even as its EM peers rallied. A falling currency amid strong economic growth is generally a symptom of an overheating economy; it signals that real interest rates are low and the central bank is behind the curve. Today, the monetary authorities need to hike borrowing rates aggressively, otherwise the currency will plunge much further. The country's financial markets are quickly approaching a riot point, and local currency bond yields are already selling off as creditors are rebelling (see bottom panel of Chart I-1 on page 1). Another option the BSP could take to defend the peso without hiking rates much is to sell foreign exchange reserves. Doing so, nevertheless, will still lead to higher domestic interest rates - especially at the short end of the curve. When a central bank sells its dollar reserves, it absorbs local currency liquidity - i.e. commercial banks' excess reserves at the central bank decline. Interbank rates then rise, which pushes up short-term rates and potentially long-term ones too. This is how financial markets naturally force macro adjustments on an overheating economy when policymakers are reluctant to act. As such, Filipino share prices are now facing a major risk. Higher domestic rates amid strong loan growth will cause the economy to decelerate significantly. Certain interest rate-sensitive sectors such as vehicle sales are already shrinking. The property sector - the segment of the economy that has benefited the most from the credit binge - will be the next shoe to drop: The supply of residential real estate buildings has been booming - floor space built has risen 2.4-fold since 2003. As interest rates continue to rise, real estate and construction loans - which are still growing at a 19% annual rate - will slump. Higher borrowing costs will hurt real estate prices. Meanwhile, rent growth will decline as the economy decelerates. The slowdown in the property sector will take a heavy toll on real estate development and management companies: First, these firms' revenues and income - property sales, rental and other types of income - will decelerate significantly (Chart I-6, top panel). Chart I-6Listed Real Estate Companies Will Face Major Headwinds Second, higher interest rates will raise their interest expenses (Chart I-6, bottom panel). Remarkably, Philippine real estate stocks have remained quite resilient, despite the broad selloff in financial markets. While the former are down by 18% in dollar terms from their early 2018 peak, Chart I-7 suggests rising interest rates herald a much more pronounced drop in their prices. Chart I-7Filipino Property Stocks Are On A Cliff Besides, these property companies are also still expensive. Their price-to-book value (PBV) currently stands at 2.9. Between the years 2000 and 2005, their PBV averaged 1.6. We are therefore initiating a new trade: Short Philippine real estate stocks in absolute U.S. dollar terms. Crucially, the real estate sector makes up 27% of the Philippines MSCI index, and will therefore have a significant impact on the Philippine stock market. As to bank stocks - the other large segment of the equity market - a couple of points are in order. Commercial banks in the Philippines are exposed to the real estate sector. Hence, a slowdown in the property sector will culminate in the form of higher NPLs and provisions for bad loans on banks' balance sheets. Real estate and construction loans account for 25% of total bank loans. Crucially, NPLs and provision levels - at 1.3% and 1.9%, respectively - are very low, and have so far not risen. This is unsustainable given the magnitude of the ongoing credit boom and rising interest rates. Higher provisions will cause banks' profits and share prices to suffer materially. This will come on top of plunging net interest margins (Chart I-8). Chart I-8Philippines Commercial Bank Profits Are Getting Squeezed As to equity valuations, this bourse is not cheap, neither in absolute terms nor relative to the EM equity benchmark - both valuation measures are neutral (Chart I-9). Chart I-9Equity Valuations Are Not Attractive Overall, the outlook for Philippine equities as a whole remains unattractive both in absolute terms, as well as relative to the EM benchmark. Bottom Line: EM equity portfolios should continue underweighting this bourse. We are also initiating a new trade: Going short Philippine real estate stocks in absolute U.S. dollar terms. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Strategy For Central European Markets Our presiding macroeconomic theme for central Europe - which we first elaborated on in a Special Report titled, Central Europe: Beware Of An Inflation Outbreak2 - has been as follows: An accommodative policy stance in the context of strong growth and tight labor markets warrants higher inflation. Our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - is continuing to surge across all central European countries as well as in Germany. This foreshadows higher wage growth ahead (Chart II-1). Chart II-1Tight Labor Markets Means Higher Wage Growth Furthermore, monetary policy in central European countries remains accommodative - policy rates are negative in real (inflation-adjusted) terms. Consistently, private credit (bank loan) growth and domestic demand remain robust. Today, we appraise and modify our investment strategy across all central European markets in general and Hungary in particular, where a policy shift is in the making. Hungary: Moving Away From Ultra-Accommodative Monetary Policy? Last month, the NBH (National Bank of Hungary) modified its monetary policy statement to include a new paragraph explaining that the council is prepared for the gradual normalization of monetary policy, depending on the outlook for inflation.3 Given our view that inflation in Hungary will continue to rise, the NBH is likely to move away from ultra-accommodative monetary policy sooner rather than later. Besides mounting inflationary pressures, several factors lead us to believe that the NBH is more comfortable normalizing policy today than in the past: First, after seven years of deleveraging, private credit is finally on the rise, and money supply growth is booming (Chart II-2, top and middle panel). Chart II-2Hungary: Easy Monetary Conditions Will Lift Inflation Second, capital expenditures are recovering and business confidence is making new highs (Chart II-3, top and middle panel). Furthermore, construction is firing on all cylinders (Chart II-3, bottom panel). Chart II-3Hungary: Capex Is Robust Lastly, core consumer inflation is rising and the real deposit rates is at -2%, the lowest in 20 years (Chart II-2, bottom panel). Given the genuine need for rate normalization in Hungary and the central bank's readiness to do so, we are adjusting our strategy: We are taking profits of 72 basis points on our Hungarian yield curve steepening trade that we initiated on June 21, 2017. Hungary's yield curve is already the steepest yield curve in Europe. The slope of the 10/1-year yield curve is 320 basis points in Hungary, versus 200 in Poland, 100 in the Czech Republic and 105 in Germany. We are closing our long PLN / short HUF trade with a 7.7% gain since its initiation on September 28, 2016 (Chart II-4). The cross rate is close to an all-time high and will likely reverse. Chart II-4Book Profits On Long PLN / Short HUF A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area (Chart II-5). Chart II-5A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates First, not only is final domestic demand in Hungary much more robust than in the euro area, but Hungary's output gap is positive while the euro area's is still negative (Chart II-6,top and middle panel). This foreshadows a widening gap in inflation between Hungary and the euro area (Chart II-6, bottom panel). As this transpires, policy rate expectations will rise faster and by more in Hungary than in the euro area. Chart II-6Hungarian Economy Will Overheat Faster Than Euro Area's Second, ultra-accommodative monetary policy in Hungary has served its purpose and has generated an overflow of liquidity. In effect, with broad money supply in Hungary now growing considerably faster than in the euro area, the NBH will likely tighten its policy at a faster pace and by more than the ECB (Chart II-7). This warrants a widening 3-year swap rate differential between Hungary and the euro area. Chart II-7Hungary Vs. Euro Area: Money Growth And Swap Rates Third, as global trade continues to slump, affecting German manufacturing, the European Central Bank will be fast to reiterate its readiness to keep policy accommodative longer than expected. This could push back expectations of the first ECB rate hike. Finally, Italy remains a risk and European banks are exposed to weakening developing countries. With euro area bank share prices plunging close to their 2008 and 2012 lows, the ECB will be both slow and cautious in signaling rate normalization in the immediate future. While Hungary is a very open economy and will feel the pinch from a slowdown in European manufacturing, its currency may depreciate further against the euro as it typically does amid global risk-off periods. A cheap currency will reduce the NBH's worries about the pass-through of a global slowdown and disinflation into its domestic economy. In short, given that both economies have different inflationary backdrops, Hungarian interest rate expectations will increasingly diverge from those of the euro area. As such, fixed-income investors should bet on a rising 3-year swap rate differential between Hungary and the euro area. Our Other Positions In Central European Markets Within the fixed income and currency space: Stay overweight CE3 within EM dedicated fixed-income portfolios. Predicated on our view that the epicenter of the ongoing global growth slowdown is China, emerging Asian and commodity leveraged markets are at much bigger risk than their Central European counterparts. Consistent with this theme, stay short IDR versus PLN. Book profits of 109 basis points on the following trade initiated on July 26, 2017: Pay Czech / receive Polish 10-year swap rates (Chart II-8). In line with our expectations,4 the Czech National Bank has been responding to rising domestic inflationary pressures and has been tightening monetary policy faster than the National Bank of Poland. There now remains little upside in Czech rates relative to Polish ones, so we are booking profits. Chart II-8Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Stay long CZK against the EUR. Widening growth and inflation gaps between the Czech Republic and the euro area justify higher rates and a stronger currency in the former relative to the latter. Regarding the equity space: Stay long CE3 banks / short euro area banks. CE3 banks are less leveraged and have a higher return on assets than euro area banks. Continue overweighting CE3 within EM dedicated equity portfolios. CE3 stocks have staged a double bottom relative to their emerging market peers, both in common and local currency terms (Chart II-9). Given emerging markets are saddled with credit excesses, unresolved economic imbalances and looming currency weakness, central Europe is likely to continue outperforming. Chart II-9CE3 Equities Will Outperform EM A summary of all our trades and asset allocations can be found on page 14 and 15. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see Emerging Markets Strategy/Geopolitical Strategy Special Report, "The Philippines: Duterte's Money Illusion," dated April 25, 2018, available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, available at ems.bcaresearch.com. 3 http://www.mnb.hu/en/monetary-policy/the-monetary-council/press-releases/2018/press-release-on-the-monetary-council-meeting-of-18-september-2018 4 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Economic data and policy announcements over the past month reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption. A review of historical episodes of "outsized" investment intensity shows that policymakers have good reason to try and shift the composition of China's economy towards consumption, as it suggests that China's current experience probably cannot be sustained. A shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. It is too soon to move towards an outright long position favoring domestic stocks, even though considerable bad news has been priced in. CNY-USD likely has further downside, and investors allocating among Chinese stocks should only favor domestic over investable equities in currency-hedged terms. Feature September's total social financing data, released earlier this month, provided important evidence supporting our view that Chinese policymakers are not aiming for a significant acceleration in private sector credit growth. Chart 1 highlights that the year-over-year growth rate of adjusted total social financing (TSF) actually ticked modestly lower in September, in clear contrast to the bet of many investors that China is following its "old stimulus rulebook". Chart 1Chinese Policymakers Are Not Pumping The Credit Taps Some market participants have pointed to the fact that adjusted TSF is rising sharply on a 3-month annualized basis after adjusting for seasonality (Chart 2), and have concluded from this fact that a sustained expansion in credit growth is forthcoming. However, Chart 3 illustrates that the pickup shown in Chart 2 is due to a surge in special local government bond issuance, which reflects front-loading of fiscal spending. Financial news outlets have reported that "provincial authorities had by the end of September already raised 92 percent of the 1.35 trillion yuan ($195 billion) worth of special infrastructure bonds that the central government has targeted for the entire year",1 implying that local government bond issuance in Q4 will drop off significantly relative to the past three months. Chart 2A Near-Term Pickup... Chart 3...Caused By Front-Loaded Fiscal Spending The September credit data aside, we acknowledge that there have been several small-scale stimulus announcements from the Chinese government over the past month. But the bottom line for now is that developments over this period reflect the view that policymakers are serious about restraining credit growth, and that they will attempt to combat any weakness in external demand by boosting domestic consumption.2 Restraining Credit Growth: Wisdom Or Folly? China's unwillingness to resort to a significant acceleration in credit growth to help stabilize its economy has surprised some investors, and raised criticism in some corners that the country is making a policy mistake. A recurring argument in this vein, particularly among perennial China bulls, is that policymakers should not be concerned about China's elevated levels of private sector debt because it is the natural and inevitable result of a high savings rate. According to this view, restraining credit growth and attempting to boost consumption merely dooms China's ability to escape the middle-income trap, because higher per capita income can only be achieved by further growth in the stock of capital. BCA's China Investment Strategy service does not dispute the notion that a high savings rate can lead to a high leverage ratio, particularly among small, fast-growing economies. But in the case of China, the sharp rise in private sector debt that has occurred since 2010 was not natural, and certainly was not inevitable. Instead, our view is that it was the result of an explicit "least-bad" choice made by policymakers to weather the reality of poor external demand following the global financial crisis. Chart 4 presents, in a nutshell, the theoretical support for the "keep investing" view. The chart depicts real per capita GDP for 80 countries in 2014 as a function of the average share of gross capital formation to GDP from 1960 to 2014. The chart clearly shows that richer countries today have tended to invest more on average in the past, which is entirely consistent with textbook economic theory. Chart 4Higher Investment Has Led To Higher Per Capita GDP Growth... However, there are two reasons why the simple inference from Chart 4 that China should just "keep investing" is deeply flawed. First, while investment as a share of GDP in China has recently declined from its 2011-2014 peak, it remains close to 45%. This is a massive rate of investment, and a historical review points to the conclusion that it probably cannot be sustained: 45% is nearly off the x-axis scale shown in Chart 4, suggesting that China's current rate of investment is not achievable over extended periods of time. In fact, the chart suggests that 30% is the highest realistic rate of investment as a share of GDP that a country can maintain over an extended period. In 2014, based on the definition of the data from the Penn World Table (GDP share of gross capital formation at current purchasing power parity), China had maintained its investment share above 30% for 12 years. At first blush, there appears to be some precedent suggesting that China's outsized investment run can go on for longer: among the 80 countries included in Chart 4, 14 of them have experienced a longer continuous run of investment as a share of GDP. However, Chart 5 shows that most of these experiences occurred in the 1960s and 1970s, when global exports as a share of GDP were rising from a very low base. This implies that historical examples of outsized investment runs have largely reflected export-driven catch-up stories, which bodes poorly for China's ability to continue to invest at its recent massive scale given that global exports to GDP appear to have peaked. Chart 5...But Very High Rates Of Investment Have Driven By Exports Second, the relationship shown in Chart 4 captures the potential gains of profitable and rational investment, or in other words the accumulation of a "useful" stock of capital. But an unfortunate reality facing savers is that while one can choose to save or invest, one cannot necessarily choose the accompanying rate of return. If China invests heavily at very low or negative rates of return, the idea that investment will lead China out of the middle-income trap is very likely wrong. As we have discussed in previous reports, there is good evidence to suggest that the marginal gains from investment in China have been falling. The private sector debt-to-GDP ratio features prominently in the case against profitable investment in China: despite a massive rise in investment and debt from 2002-2007, the private sector debt-to-GDP ratio barely rose, because this debt was used to accumulate capital that verifiably delivered nominal GDP growth. Yet following 2010 the ratio rose sharply, implying that the returns from the investment that has taken place over the past decade have been (at least so far) considerably lower than those of the prior decade. Also, we noted in our August 29 Special Report that state-owned enterprises (SOEs) have accounted for a sizeable portion of the private sector leveraging that occurred after 2010,3 and that the marginal operating gain from debt for SOEs has become negative (Chart 6). A gap between the cost/return on borrowed funds strongly implies that the investment channeled through SOEs over the past several years does not represent, on balance, the accumulation of useful capital. Chart 6Strong Evidence Against Productive SOE Investment In our view, a cohesive story emerges from the above analysis, one that counters the view that China is making a policy mistake by trying to avoid another significant episode of private sector leveraging. China's enormous catchup in per capita GDP over the past 20 years was initially export-led, but was sustained after 2010 by quasi-fiscal spending in the form of a material leveraging of state-owned enterprises. This shadow government spending was aimed at preventing large-scale job losses, but proved to be considerably less productive than the private, export-driven investment-boom that preceded it. This suggests that China is simply investing too much for an economy that needs to accumulate capital for the purposes of domestic production, and that any further, aggressive leveraging of the private sector will simply raise the odds or the cost of the eventual bailout. While investors who are hoping to profit from China's credit excesses may wish for a different outcome, the bottom line is that Chinese policymakers will act in the best interests of their country, and they have good reason to try and shift China's economy away from extremely high rates of investment towards more consumption. Implications For Investment Strategy As would be the case in any other major country, we have no doubt that Chinese policymakers will eventually move to a maximum reflationary stance (which would imply a significant reacceleration in credit growth) if they feel that the existing slowdown will lead to deep, threatening economic instability. The key point for investors is that a desire of policymakers to shift even somewhat away from heavy investment-led growth means that the "strike price" of the China put option has fallen relative to past economic slowdowns, implying that it will take more pain before investors can cash in. Within the universe of Chinese financial assets, there are three pertinent investment strategy questions that arise from this reality: Even if there is more pain to come, Chinese domestic stocks have fallen 30% in local currency terms, and close to 40% in U.S. dollar terms (Chart 7). Is it time to go outright long? Should investors allocating among Chinese stocks favor domestic or investable equities? What is the outlook for CNY-USD? For now, our answers are as follows: 1) not yet, 2) domestic over investable in currency-hedged terms, and 3) weaker (possibly significantly so). Chart 7The Bear Market In A-Shares Is Advanced... We agree that 30% is a reasonable estimate of the likely decline in domestic earnings over the coming year, which normally would suggest that A-shares have fully priced the bad news and that investors should consider buying. However, there are two key reasons why we think this conclusion is premature: We noted in our September 19 Weekly Report that the lesson of 2014/2015 was Chinese stocks needed both policy stimulus and earnings clarity before bottoming.4 For now, China's stimulative response has been measured, and we have yet to see any decline in domestic 12-month forward earnings (Chart 8). While it is not the only factor contributing to the decline, the escalation in the trade war with the U.S. acted as a clear negative catalyst for the Chinese stock market. We have argued that the evolution of the trade positions of both sides suggests that the imposition of a third and final round of import tariffs covering all Chinese exports to the U.S. is likely, which would further reduce Chinese earnings visibility for investors. News reports this week suggested that an announcement to this effect could occur in early-December, if a meeting between Presidents Trump and Xi is called off or fails (as we expect). Chart 8...But Forward EPS Have Yet To Start Falling Chart 9 presents our framework for forecasting CNY-USD as a function of various U.S. import tariff scenarios, which we used to argue that a break above the psychologically-important level of 7 for USD-CNY appeared likely barring strong action from the PBOC4. The RMB has weakened in line with our view over the past month, and Chart 9 shows that it stands to weaken further, potentially significantly, if the U.S. does move ahead with a 25% import tariff on all imports from China. Chart 9Further Downside In CNY-USD Is Likely Finally, our negative outlook for the currency informs our view that a relative position favoring domestic over investable stocks should be currency-hedged. Chart 10 shows that an uptrend in relative performance does appear to be forming in local currency terms, but not in U.S. dollar terms (due to the recent renewed weakness in CNY-USD). Chart 10Relative To Investable Stocks, Only Favor A-Shares In Hedged Terms We opened a shadow trade in our July 5 Weekly Report of being long the MSCI China A Onshore index / short MSCI China index,5 which we said we would consider implementing in response to a 5% rally in relative performance. Our intention was to structure this trade in unhedged terms (consistent with most of the trades in our trade book), and our judgement is that it is simply too early to do so despite the fact that a 5% relative rise in U.S. dollar terms has indeed occurred. Signs of a durable bottom in CNY-USD, or an assessment of minimal further downside coupled with strong outperformance of domestic stocks in local currency terms, are likely catalysts for a green light. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "China Is Struggling To Find Projects To Spend Bond Splurge On", Bloomberg News, October 22, 2018. 2 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights So What? The bull market in defense stocks is global and only beginning. We construct a BCA Global Defense Index to give investors exposure to this theme. Why? Multipolarity will drive uncertainty and conflict, spurring arms demand to Cold War heights. Contemporary geopolitical hotspots require expensive and modern technology. Cold War-era weapon systems are long in the tooth and in need of replacement. Also... We close our long Energy / short S&P 500 portfolio hedge for a gain. Feature It is somewhat of a cliché to tell clients that one of our highest conviction calls is to be overweight defense stocks. We are, after all, geopolitical investment strategists! Our decision to go long S&P 500 aerospace and defense stocks / short MSCI ACW is up 14% since initiation in December 2016. In this report, we build on previous work focusing on U.S. defense stocks and expand our analysis to global plays. GPS' Mega-Theme: Multipolarity Is Good For War International affairs are characterized by an anarchic governance structure. In the absence of a global government, the vacuum of power is filled by powerful states. These states behave like bullies in the schoolyard. When a single, powerful bully dominates the lunch break, all other kids fall in line or suffer the bully's wrath. When two bullies split the yard into warring camps, proxy fights may emerge on the sidelines, but generally an equilibrium is preserved. Formal political science theory and history teach us that the further we are from a hegemonic global structure where one country (the hegemon) dominates and bullies all others, the closer we are to anarchy. The "offensive realism" school of International Relations theory further splits multipolarity into two types: Balanced multipolarity is characterized by a number of roughly equally powerful states, similar to the distribution of power of continental Europe during the "Concert of Europe" era in the nineteenth century. Unbalanced multipolarity is closest to contemporary geopolitics. In The Tragedy Of Great Power Politics, John Mearsheimer reviewed 200 years of European history and concluded that unbalanced multipolarity is by far the most volatile geopolitical system (Table 1).1 Table 1Global System Structure And War A multipolar ordering of global power, therefore, produces the highest level of disorder (Chart 1). This finding is theoretically elegant, but normatively disturbing. Every country gets a voice and an opportunity to defend its sovereignty. But the international order is normatively ignorant and desires a bully or hegemon. Chart 1Multipolarity Produces Disorder Over the past fifty years, there have been three identifiable periods in the global arms market (Chart 2): Chart 2Further Upside In The 'War Bull Market' Cold War Arms Race - 1961-1982: The arms trade grew by a whopping 177% during this period, with an average annual growth rate of 5.5%; Disarmament - 1982-2002: Arms trade shrunk by 61% and average annual growth rate was -3.9%; Multipolarity - 2002-present: What started with the U.S. defense buildup following 9/11 has evolved into a truly global response to emerging multipolarity. The arms trade grew by 73% from 2002 to 2017, with an average annual growth rate of 3.4%. Bottom Line: In 2017, the total arms trade was 68% of its peak in 1982, signifying that we have more room to go in this recent "War Bull Market." Given that unbalanced multipolarity produces a higher volume of conflict than a bipolar system, we would expect the current phase to be more fruitful for the global arms race than even the Cold War era. The Pillars Of An Arms Bull Market Chart 3Global Defense Spending... In this report, we focus on the global arms trade, which is different from global defense spending (Chart 3). This is because global defense spending includes non-investible transactions, such as spending on salaries, buildings, health care, and pensions. The global arms trade was once 20% of global defense spending, but is now only 1.9% (Chart 4). Chart 4...Is Different From The Global Arms Trade The reason is that salaries and pensions now dominate defense budgets. In the U.S., they make up 42% of all expenditure. They are higher in much of the developed world (66% in Italy, for example). Moreover, many countries that in 1960 did not have an armaments industry have become quite adept at satisfying demand via domestic production. We nonetheless would expect the global arms trade to bounce off of its lows today. There are three main reasons. Evolving Conflict Zones: Asia And Europe The primary reason to expect a brisk pickup in the global arms race is that the global conflict zones are evolving. Multipolarity is causing shifting geopolitical equilibriums. We expect both East Asia and Europe - largely dormant as hotspots since the end of the Cold War - to catch up with the Middle East as zones of tensions. Periods of rising conflict tend to coincide with the rise in the global arms trade (Chart 5). Chart 5Rising Conflict Coincides With Escalating Arms Trade East Asia is our primary concern. Sino-American tensions have been brewing for decades, well before the trade war initiated by the Trump administration. Recently, the trade war has begun to spill into strategic areas (Table 2), creating a vicious feedback loop that could spark an accident or outright military conflict. Table 2Trade War Spills Into Strategic Areas The South China Sea is the premier geographic location of U.S.-China strategic friction. It is a hub for international trade, a vital supply route for all major Asian economies, and the premier focus of China's attempt to rewrite global rules (Diagram 1). We update our list of clashes in this area in Appendix A. Diagram 1South China Sea As Traffic Roundabout China has used its growing economic heft in the region to bully its neighbors into acquiescing to its geopolitical posture (Chart 6). It has used economic sanctions, trade boycotts, and tourism bans to get its way with the neighborhood. China's East Asia neighbors - including Japan - will look to balance their growing dependence on the Chinese economy with a desire to maintain sovereignty. One way to do so will be to rearm and present a formidable challenge to Beijing's regional hegemony. This means that not only the South China Sea but also China's entire periphery is at risk of friction, and this is true regardless of any U.S. interest in Asia. Chart 6China Uses Its Economic Might To Bully Europe is also growing as a potential source of global arms demand. Since the end of the Cold War, Europe has seen a decline in defense spending. One reason is the NATO alliance, which has allowed Europeans to pass the buck to the U.S. This has not only been the case with the safely cocooned Western European states. Poland, intimately familiar with the built-in geopolitical risks of its neighborhood, reduced its defense spending once it joined NATO. President Trump has made awakening Europe from its stupor a key pillar of his trans-Atlantic policy. A combination of Trump's pestering and concerns that the U.S. is trending towards isolationism with an evolving threat matrix that now includes terrorism, migration, and Russia should be enough to spur Europeans to meet their commitment to spend 2% of GDP on defense (Chart 7). Chart 7Europeans Will Be Swayed To Meet Defense Commitments... If NATO member states and Japan were to respond to their evolving threats and commit to spending 2% of GDP on defense, the impact on global arms demand would be significant. The extra spending would be roughly $145 billion, a 14% increase from current levels (Chart 8). Chart 8...Raising Global Arms Demand What about the Middle East? In the short term, we are concerned that President Trump's "maximum pressure" policy could lead to kinetic action against Iran. In the medium and long term, we expect some form of an equilibrium to emerge in the Middle East that would keep regional demand for weapons stable at current elevated levels. Saudi Arabia has been the primary importer of weapons, with 13% of total demand since 2002. Saudi purchases have accelerated as the U.S. has geopolitically deleveraged out of the region (Chart 9 and Chart 10). Chart 9As The U.S. Military Deleverages... Chart 10...The Saudi Arabian Military Leverages Evolving Technological Demands The U.S. invasion of Afghanistan and Iraq at the beginning of this century was probably the last large-scale mechanized conflict involving large formations of main battle tanks (MBT). The evolving threat matrixes in East Asia and Europe are likely to create a growing demand for naval, air superiority, and drone/autonomous technology. In East Asia, the two main risk theaters are the South and East China Seas. In Europe, the Mediterranean, the Baltic, and the Black Seas are increasingly becoming a risk vector due to the instability of North African and Middle East countries, as well as Russian assertiveness. This is good news for the arms industry as aircraft and ships are some of the most lucrative exports given the high level of technological sophistication that goes into developing them (Chart 11). A war fought in the trenches and jungles by soldiers and insurgents is unlikely to be very profitable, other than for small arms manufacturers. But tensions between sovereign nations across large distances and bodies of water will be highly lucrative for major defense manufacturers that specialize in anti-access/area-denial systems.2 Chart 11Aircraft And Ships Are Most Lucrative Furthermore, capital depreciation is advanced for the most sophisticated (and thus expensive) military technology that was introduced at the tail-end of the Cold War expansionary phase. The U.S. aircraft carrier fleet, for example, is mostly made up of Nimitz-class carriers, which have served for the past 43 years on average (Chart 12). Chart 12Capital Depreciation Is Advanced Our back-of-the-envelope calculations show that the cyclicality in U.S. aircraft carriers is apparent across the major defense systems. Looking at 40 countries and their respective aircraft and MBTs, the bulk of these weapons is beyond the average age of the previous generation when it was retired (Chart 13). Part of the reason for the extended life cycle is better technology, but we suspect the main reason is that these major weapon systems were developed at the height of the Cold War and have not been updated since then. Chart 13Weapons Are Beyond Retirement Age, Need Updating Population Aging The demographic trends of population aging and low birth rates have wide-ranging macroeconomic implications. But they will also impact the defense industry by encouraging automation. There are benefits to automation in the military sphere beyond simply replacing a shrinking pool of able-bodied youth. First, the likely geopolitical hotspots of this century - East Asian seas, the Persian Gulf, the Black Sea, the Mediterranean, and the Indian Ocean - are conducive to high-tech warfare. These bodies of water will be patrolled by drones and plied by autonomous surface vessels while hypersonic missiles deny access to the enemy. Second, by shifting the burden of fighting wars from humans to robots, policymakers will face lower constraints to conflict. This development will not only encourage policymakers to develop autonomous weapon systems, but might also increase the frequency with which they are used, destroyed, and thus re-ordered, shortening the hardware life-cycle and thus increasing the sales volume. Bottom Line: Global multipolarity has seen the U.S. geopolitically deleverage from the Middle East, threaten Europe with abandonment, and put pressure on China in East Asia. These are trends that we believe are here to stay irrespective of President Trump's success or failure in the 2020 election. They are all bullish for defense spending and arms trade. In addition, evolving technological demands and global demographic trends will buoy the arms trade. We expect this era of unbalanced multipolarity to be even more lucrative for global defense contractors. The U.S.: Remain Overweight Anastasios Avgeriou, BCA's chief U.S. equity strategist, recommends that investors remain overweight the pure-play BCA defense index and add exposure to it on any meaningful pullbacks while keeping it as a structural overweight within the GICS1 S&P industrials index. In the U.S., defense spending and investment have bottomed and will continue to accelerate. The Congressional Budget Office (CBO) continues to project that defense outlays will jump further next year (middle panel, Chart 14). We expect that this breakneck pace is actually sustainable, mainly because any fiscal compromise with Democrats on discretionary, non-defense spending would require acquiescence on GOP spending priorities, such as defense. Defense outlays will therefore continue to expand into the 2020s. Chart 14Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs and represents a boost to defense equity revenue growth prospects. Defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 15). Chart 15...And A Flurry Of M&A Is A Boon For Defense A closer look at operating metrics corroborates the view that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 16). Chart 16Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20% annually, or twice as fast as overall capex (Chart 17). Defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 18). Chart 17Industry Is Not Standing Still Chart 18Healthy Balance Sheet With High ROE... Valuations are on the expensive side and in overshoot territory (Chart 19). This is clearly a risk to the overall view. However, if our structural thesis pans out, then defense stocks in the U.S. will grow into their pricey valuations as happened in the back half of the 1960s. Chart 19...But Valuations Are Expensive Bottom Line: The secular advance in pure-play defense stocks remains in place. BCA's U.S. Equity Strategy recommends an above-benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLC, NOC, GD, and RTN. Global Stocks: Be Discerning Beyond the U.S., which global defense stocks are appealing? We believe that there are several market and structural factors to consider. We have ranked national defense sectors by market and structural factors in Tables 3 and 4. Further, Appendix B lists all the non-U.S. weapon manufacturers that we examined, as well as market performance by country. Table 3Russian Defense Sector Attractive On Market Factors Table 4European Companies Rank Highly On Structural Factors Momentum - We like stocks from equity markets that have momentum behind them, i.e. whose stock are above their 200-day moving average. Relative valuation - We like defense sectors that are at a discount relative to the U.S. plays. Performance since Trump - For any country that has outperformed the U.S. aerospace and defense sector since the inauguration of President Trump on January 20, the market believes in its competitiveness vis-à-vis the largest exporter. Geographical diversity - We have ranked country defense sectors by how diverse their sources of revenue are. The higher the figure, the more geographically diverse the revenue pool. Russian and Indian defense plays score very low on this variable as they depend solely on one source: themselves. Exposure to arms trade - We have ranked country defense sectors by how exposed their contractors are to defense as opposed to civilian production. Most companies have major civilian outlays. To fully capture our multipolarity theme, we have ranked companies based on how fully focused they are on producing and selling weapons. Share of global arms market - We recommend that clients buy defense companies in countries that already have a high share of the global arms market. Decisions on purchasing weapons often involve path dependency due to the need to acquire compatible systems. Defense spending - We penalize countries that are already spending 2% of GDP on defense. Their companies will see little boost to domestic demand. It is the other, under-spending countries that will significantly increase their outlays over the next decade. Russian companies score high on market factors. They have good momentum, are attractively valued relative to the U.S. aerospace and defense sector, and are structurally supported. Israel, Canada, Australia, and Brazil are also attractive. All of these are made up of only one stock. On structural factors alone, we like German, British, Italian, and Swedish defense companies. They are geographically diversified, have a respectable share of the global arms trade, and have both reason and room to increase domestic spending. French companies are also structurally attractive, although France may have less need to increase defense outlays. Putting it all together, we are creating a BCA Global Defense Basket. We would include the following global tickers in that basket: A:ASBX, F:AIRS, F:CSF, F:SGM, F:AM@F, C:CAE, D:RHM, D:TKA, I:LDO, I:FCTI, ULE, COB and W:SAAB. Clients may want to include in the basket the five U.S. tickers recommended by BCA's U.S. Equity Strategy: LMT, LLL, NOC, GD, and RTN. We recommend that investors buy this basket, in absolute terms, as a structural investment. Housekeeping We are closing two of our hedges today. First, we are closing long Brent / Short S&P 500 for a gain of 6% and our long U.S. energy / short U.S. information technology for a loss of 1.63%. We initiated the two tactical trades on October 3, which means we timed the market correction perfectly. However, concerns over a supply glut in the oil market meant that the "long" part of our trade did not work out. Furthermore, there have been leaks from the White House to the media that the U.S. may award exceptions to the oil embargo to several critical importers. This would suggest that the Trump administration is beginning to see the risks of its aggressive maximum pressure strategy toward Iran and therefore may be trying to backtrack from it. We still think that the odds of an oil spike due to geopolitics in 2019 are high, but they do appear to be declining, at least for the time being. As such, we are closing the two trades for a net gain. We will continue to monitor the Iran embargo carefully as we expect that geopolitical risks will again be understated in the future, offering investors another opportunity to be long energy. Jesse Anak Kuri, Consulting Editor jesse.anakkuri@mail.mcgill.ca 1 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: W.W. Norton & Company, 2001). 2 Anti-access/area-denial (A2/AD) is a strategy of preventing an adversary from occupying or transiting a geographic area. Defense systems that perform A2/AD functions in the modern era tend to be expensive and technologically sophisticated. They include anti-ship missiles, sophisticated radars, attack submarines, and air-superiority fighter jets. Appendix A Notable Clashes In The South China Sea (2010-18) Notable Clashes In The South China Sea (2010-18) (Continued) Notable Clashes In The South China Sea (2010-18) (Continued) Appendix B Appendix B Chart 20British Defense Stocks Appendix B Chart 21French Defense Stocks Appendix B Chart 22German Defense Stocks Appendix B Chart 23Italian Defense Stocks Appendix B Chart 24Swedish Defense Stocks Appendix B Chart 25Norwegian Defense Stocks Appendix B Chart 26Canadian Defense Stocks Appendix B Chart 27Australian Defense Stocks Appendix B Chart 28Korean Defense Stocks Appendix B Chart 29Japanese Defense Stocks Appendix B Chart 30Singaporean Defense Stocks Appendix B Chart 31Israeli Defense Stocks Appendix B Chart 32Russian Defense Stocks Appendix B Chart 33Brazilian Defense Stocks Appendix B Chart 34Indian Defense Stocks Appendix B Chart 35Turkish Defense Stocks Appendix B Table 1Key Aerospace And Defense Companies Appendix B Table 1Key Aerospace And Defense Companies, Continued