Financial Markets

Special Report

Highlights A supply-driven spike in oil prices in early 2019 is now a highly likely scenario. This represents a potential risk to our current high-conviction view that global bond yields will continue to rise over the next year. Oil prices north of $100/bbl would have negative implications for global growth, especially with a rising U.S. dollar likely to magnify the inflationary impact outside the U.S. A spike in oil prices could alter the recent positive correlation between global bond yields and oil (through higher inflation expectations), even turning into a negative correlation (through weaker expected economic growth). The most reliable historical correlations suggests that more volatile oil prices will lead to greater volatility for both bond yields and corporate credit spreads. Feature The BCA house view remains unequivocally bond bearish, led by additional upside potential for U.S. Treasury yields. The Fed will continue to deliver a steady pace of rate hikes over at least the next year in response to a strong U.S. economy that is fueled by fiscal stimulus and operating well beyond full employment. U.S. bond markets are not discounting enough potential tightening and inflation expectations remain below levels consistent with the Fed's 2% inflation target, so Treasury yields have room to rise further. While we are comfortable with our high-conviction bearish view on government bonds, we recognize that it is prudent to look for potential scenarios that could derail our base-case scenario. Especially since our once out-of-consensus expectation of higher global yields is now a widely-held view among investors, with Treasury yields breaking out to new cyclical highs in recent weeks. One such risk could come from a spike in oil prices in early 2019, and its potential aftermath. A confluence of geopolitical (Iran, Venezuela) and monetary policy risks (Fed tightening, rising U.S. dollar) will likely stoke oil price volatility next year. This will eventually lead to higher bond market volatility both in developed markets (DM) and emerging markets (EM) - a relationship that has had a far more reliable correlation over time than the direct relationship between oil prices and yields (Chart 1). Chart 1Oil Vol & Bond Vol Are Linked In this joint Special Report, BCA's Commodity & Energy Strategy and Global Fixed Income Strategy services explore how a changing relationship between oil and interest rates could affect the future behavior of global bond markets and, by association, returns to fixed income portfolios. Growing Odds Of A 2019 Oil Price Spike Global oil markets are tightening. While oil demand growth is slowing somewhat, exports from two of OPEC's largest producers - Iran and Venezuela - are falling precipitously. U.S. sanctions against the former, and the unabated collapse in the latter's economy will together remove some 2mm barrels/day (b/d) of supply from an already tight market next year. Global oil inventories are drawing down, while spare capacity is perilously low, leaving little in the way of readily available backup supply to deal with an unplanned production outage even in a minor oil-exporting state. The confluence of these factors is setting the global oil market up for a supply shock, which could take prices to $100/bbl in 1Q19 (Chart 2).1 Those high prices are likely to be sustained, and we expect Brent crude oil, the global benchmark, to trade at $95/bbl on average over the course of next year. Chart 2Get Ready For $100/bbl Oil In Q1 2019 Against this physical reality, the Fed remains set to continue normalizing interest rates. With other major central banks remaining relatively accommodative, widening rate differentials (Chart 3) will continue to support the U.S. dollar (USD). This will, all else equal, increase the cost of oil in local currency terms outside the U.S., hitting EM economies particularly hard if the price move is both as large, and as rapid, as we expect. Chart 3Rate Differentials Will Remain USD-Supportive It is important here to differentiate between a steady demand-driven rise in the price of oil and a rapid supply-driven oil price spike. The former can be bond-bearish by pushing up the inflation expectations components of global bond yields at a time when strong economic growth is also pushing up real bond yields. An oil price spike, however, can eventually produce a DIS-inflationary impulse by depressing real economic growth and destroying oil demand, which ultimately lowers oil prices, inflation expectations and real yields. The IMF, in its most recent World Economic Outlook, highlighted a scenario for 2019 where a big enough rise in oil prices could even cause the Fed to reverse its rates-normalization policies.2 While this is not BCA's base case view, a period of sharply higher oil prices in 1Q19 followed by lower prices in 2H19 would whipsaw global oil markets and raise oil price volatility. History suggests that bond price volatility is likely to also increase in the process, both for government bonds (through more uncertainty over the future path of inflation and policy rates) and corporate bonds (though more uncertainty over future economic growth). Expect Higher Bond Volatility As Oil Volatility Rises Since the end of the Global Financial Crisis (GFC), oil volatility has strongly influenced volatility in DM and EM bond markets. Indeed, we find all grades of corporate and junk bonds grouped together are highly correlated with oil volatility in the post-GFC period. We expect this to continue going forward, as oil inventories are drawn down globally to meet consumer demand for refined petroleum products like gasoline, diesel fuel, chemicals and plastics. The drawdown in global inventories shows up in a backwardated oil-price forward curve, which reflects the increasing inelasticity of supply.3 This means prices have to adjust more frequently and sharply to equilibrate available supply with demand, producing higher volatility in oil prices (Chart 4). Chart 4Implied Volatilities Will Rise As OECD Storage Falls Using principal components analysis (PCA), we find a high pairwise correlation between oil and bond volatility since 2010. The first principal component (PC) of all grades of corporate and junk bonds grouped together varies strongly with oil volatility, with a correlation of 0.80. Importantly, this component explains 91% of the variability in the group (Chart 5).4 EM bond spreads for smaller issuers like Chile, Peru, Hungary, Poland, Turkey, Indonesia, Mexico, Colombia, and Malaysia are also heavily influenced by greater variability of oil prices, with the first PC of this group highly correlated with oil volatility. Chart 5Oil Volatility Leads To Bond Volatility It comes as no surprise that our U.S. Bond Strategy group, headed by Ryan Swift, has found that lower-quality corporate bonds (i.e., junk) have a high correlation with oil volatility, as do lower-quality corporate spreads (Chart 6). As Ryan noted in a recent report: "there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa. ... The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads."5 Chart 6Higher Oil Vol = Wider Junk Spreads Oil Volatility Leads To Credit Spread Widening Thus, the oil price spike that we are expecting in 2019 should make corporate bond investors more cautious on the outlook for credit spread and expected returns. BCA's bond strategists have already been expecting to shift to an underweight stance on U.S. corporate debt sometime in 2019 as the Fed moves to a restrictive monetary stance and investors begin to cut U.S. growth expectations and anticipate increased future credit downgrades and defaults. A sharp upward move in oil prices in 1Q19 may prove to be the trigger for that shift to a more bearish outlook on credit. Could An Oil Price Spike Change The Fed's Current Thinking? The combination of an oil price spike and a stronger USD that we anticipate would present a considerable headwind to EM economic growth. Econometric modelling work done by BCA Commodity & Energy Strategy shows that there is a strong correlation between EM growth and U.S. inflation (see Box 1).6 Correlation is not causation, of course, but there is a plausible mechanism for that correlation through the USD, which impacts both EM growth and U.S. inflation. Box 1 Modeling The Links Between The USD, EM & Inflation The two risks we highlight in this Special Report - an oil-price shock in 1Q19 that occurs while the Fed is tightening - have profound implications for EM economies, which makes them particularly important for fixed-income markets globally.7 The near-term effects of an oil-supply shock that quickly sent prices above $100/bbl will hit EM consumers particularly hard. Many governments relaxed or removed fuel subsidies shielding consumers from high oil prices following the OPEC-engineered oil-price collapse of 2014 - 16, which saw Brent crude oil prices - the global benchmark - fall from more than $110/bbl in 1H14 to close to $25/bbl in early 2016.8 An oil-price spike would consume a far larger share of EM households' disposable income now, and would reduce aggregate demand. The second risk - tightening of the Fed's monetary policy - is more complicated. The U.S. economy separated itself from the rest of the world with strong growth this year, partly aided by fiscal stimulus. As a result, the U.S. economy is operating beyond full employment, and wages are growing smartly. This growth allows the Fed to tighten monetary policy, which likely produces four policy-rate rate hikes this year, and, per our House view, four next year. On the back of the Fed's rates-normalization policy, the U.S. trade-weighted dollar appreciated ~ 8% this year. We expect continued strength next year. As the dollar strengthens, EM trade volumes slow. This is partly a result of rising local-currency costs ex U.S., as most commodities are priced in USD. Trade volumes - particularly imports - are closely tied to EM incomes: The World Bank estimates the income elasticity of trade in EM economies averaged 1.5% from 2000-07 p.a., and 1.2% from 2010-17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period.9 Falling trade volumes correspond with weakening or falling income in EM economies. Part of this likely is explained by the expansion and deepening of Global Supply Chains (GSCs) over the past two decades, which fueled the rapid rise in trade of intermediate goods globally, and EM incomes in the process.10 To examine the impact of a rising dollar on EM income, we estimated a regression for the level of EM import volumes using an ensemble of models for the broad trade-weighted index (TWIB) USD as an explanatory variable.11 Our modeling indicates that a 1% increase in our USD TWIB ensemble translates into a 0.33% decline in EM import volumes (Chart 7).12 Chart 7Strong Dollar Dampens EM Trade Volumes Downward Trend In EM Trade Will Continue As USD Strengthens ... Next, we wanted to take these results and have a closer look at inflation, since, as noted above, wage and price pressures have been transmitted globally through GSCs for the better part of the 21st century. This is a phenomenon that accelerates as GSCs are broadened and deepened. More precisely, we wanted to examine the global aspects of local inflation in DM and EM economies.13 To do this, we look at the level of the U.S. Consumer Price Index (CPI) as a function of EM import volumes. Our modeling indicates that a 1% change in the level of EM import volumes as a function of the USD TWIB translates to a change (in the same direction) in the level of U.S. CPI of between 0.15% and 0.25% - estimated over the post-GFC period (2010 to now). This reflects both the direct and indirect effects of EM incomes on domestic inflation in the U.S. (Chart 8): Chart 8U.S. CPI Vs EM Import Volumes U.S. CPI Vs EM Import Volumes A stronger USD lowers expected U.S. inflation by reducing the cost of imports. EM disposable income growth slows as the USD rises, because the local-currency costs of imports rise and consumes more of available household budgets. Our modeling isolates the common deterministic trend between the U.S. CPI and EM import volumes from the cyclical variations. In fact, these two variables expressed in levels exhibit a strong and stable common trend.14 The U.S. trade-weighted dollar index has already appreciated 8% this year, with more upside likely in the next 6-12 months (Chart 9).15 This would widen the existing sharp divergence between a strong U.S. economy and weaker non-U.S. growth, putting even more upward pressure on the USD. This would represent an additional tightening of U.S. monetary conditions on top of the Fed rate hikes that have already occurred since late 2015. Chart 9Expect Continued USD Appreciation BCA's bond strategy services have described a concept known as the "Fed Policy Loop" to explain the link between global growth divergences, a rising USD, financial market volatility and eventual shifts in the Fed's hawkish bias. Such a move occurred in late 2015/early 2016, when the Fed had to delay additional increases beyond the initial 25bp rate hike of the current tightening cycle because of a soaring USD and global financial market instability (Chart 10). Chart 10Is The Fed Policy Loop: Watch U.S. Credit Spreads The current backdrop shares some characteristics with that episode, in terms of growth divergences (top panel), USD strength and wider EM credit spreads (second panel). The missing piece today is a large widening of U.S. credit spreads, and U.S. credit market underperformance versus Treasuries (third panel). The U.S. economy is in a much healthier place now compared to three years ago, which is why credit spreads have remained much better behaved in 2018. The global backdrop is also far less disinflationary, with the global output gap now closed and inflation expectations drifting back towards pre-crisis levels consistent with central bank inflation targets (Chart 11). Investors should focus on U.S. corporate bond spreads for signs that a stronger USD is starting to impact U.S. corporate profits and future U.S. growth expectations. This would be the most likely potential trigger for the Fed to pause on its current tightening path, as occurred in early 2016 (bottom panel). Importantly, we firmly believe that the Fed's hurdle for backing off the rate hikes from a tightening of financial conditions is much higher now because the U.S. economy is stronger today. A "garden variety" equity market correction, without much widening of corporate spreads, will not be enough. Investment Implications What we have laid out in this report is a risk to the current BCA house views on global duration exposure (stay below-benchmark) and global credit exposure (stay neutral, but favoring the U.S. over Europe and EM) - a supply-driven spike in oil prices, combined with additional increases in the USD fueled by Fed tightening. The potential trigger for that oil spike is largely geopolitical, stemming from the likely loss of oil supply from Iran via U.S. sanctions and Venezuela through economic collapse. The timing of either outcome is difficult to pin down precisely, but sometime in the first quarter of 2019 is our current best guess for when oil prices reach $100/bbl. The key variables to watch will be the U.S. dollar. If it stays stable, then the impacts on global growth and U.S. inflation from the oil spike could be more modest. If the USD surges higher, then the negative impact on non-U.S. growth will eventually spill back into the U.S. economy. The combination of more volatile oil prices and a stronger USD would be a likely trigger for a surge in U.S. bond volatility and wider corporate bond spreads. Eventually, this could move the Fed to pause on its rate hike cycle and, at least temporarily, end the current bond bear market. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Our full oil-price forecast is available in the September 20, 2018, issue of BCA Commodity & Energy Strategy, in a report titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. We will be updating our oil-price forecast next week. 2 Please see the IMF's World Economic Outlook for October 2018, which can be found here https://www.imf.org/en/Publications/WEO/ 3 Backwardation is a term of art in commodity markets used to describe an inverted forward curve - i.e., prompt prices for commodities delivered in the very near future trade higher than prices for commodities delivered further out in time. This is the market's way of signaling supplies are tight; storage holders are being incentivized to release oil in inventory via higher prices for prompt delivery. The opposite of this is referred to as a contango market (prompt prices are lower than deferred prices). Contango markets reflect well-supplied markets, as supply that cannot be immediately used must be stored for later use. In recent research, we were able to extend findings from academic studies that showed a non-linear relationship between oil volatility and the slope of the forward curve - highly backwardated and contango forward curves are accompanied by higher volatility in oil prices, due to the physical constraints on storage in such markets. 4 Principal components analysis (PCA) is a statistical technique used to reduce the most important information contained in a large number of correlated variables into a smaller number of common factors that explains the larger set. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Oil Supply Shock Is A Risk For Junk," dated October 9, 2018, available at usbs.bcaresearch.com. 6 EM trade volumes - particularly imports - are a key variable we use to track EM income levels. The World Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. Please see "Trade Wars, China Credit Policy Will Roil Global Copper Markets," in the June 21, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 10 of the 11 post-WW2 recessions in the U.S. were preceded by an oil-price spike. Since 1970, the combination of an oil-price spike and a Fed rate-hiking cycle resulted in recession. Please see "Oil-Supply Shock, Risking U.S. Rates Favor Gold As A Portfolio Hedge," published by BCA Research's Commodity & Energy Strategy on September 13, 2018. It is available at ces.bcaresearch.com. 8 Please see the Special Focus in the World Bank's January 2018 Global Economic Prospects entitled "With The Benefit of Hindsight: The Impact of the 2014 - 16 Oil Price Collapse." 9 We discuss this in "Trade Wars, China Credit Policy Will Roil Global Copper Markets," in the June 21, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Global value chains and the increasingly global nature of inflation," by Raphael Auer, Claudio Borio, Andrew Filardo, published online April 28, 2017, by VOX, the CEPR Policy Portal. 11 We average estimates from five different USD regressions using monetary policy variables, commodity prices and momentum indicators. The period covered is the post-GFC (2010 to now). 12 The regression we estimate includes a trend variable, which allows us to separate out the cyclical aspects of trade (i.e., imports) alone. 13 Please see "The globalisation of inflation: the growing importance of global value chains," by Raphael Auer, Claudio Borio and Andrew Filardo, which was published by the Bank For International Settlements in January 2017. 14 We believe this reflects "hidden variables" that simultaneously drive U.S. inflation and EM incomes such as global growth and global money/credit growth. The coefficient range we report - 0.15% to 0.25% - controls for this. For a discussion of "hidden variables," please see Clive Granger's 2003 Nobel Lecture entitled "Time Series Analysis, Cointegration, and Applications." 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ...Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com.

Highlights Duration: Our Fed Policy Loop provides a framework for understanding last week's equity market correction and its implications for future Fed policy. So far, the equity sell-off is not severe enough to deter the Fed. Maintain below-benchmark portfolio duration. Credit: With the Fed lifting rates and the market still not priced for the likely pace of hikes, it is highly likely that we will witness further periods where corporate spreads and Treasury yields rise in unison. We recommend steps investors can take to insulate their portfolios from this risk. Inflation: The macroeconomic environment remains highly inflationary. The unemployment rate is very low and wage growth is rising. However, recent trends suggest that the year-over-year growth rate in core CPI will stay close to its current level, near the Fed's target, for the next six months. This will not alter the Fed's "gradual" +25 bps per quarter rate hike pace. Feature Chart 1The Second Rate Shock Of 2018 Last week's equity market rout was the second time this year that stocks reacted negatively to a sharp rise in bond yields (Chart 1). As was the case in February, our Fed Policy Loop remains the appropriate framework for understanding the relationship between bond yields and the stock market (Chart 2).1 It can be explained as follows: Chart 2The Fed Policy Loop Step 1: The perception of easy Fed policy fuels strong performance in the stock market. Rising stock prices and "easing financial conditions" cause economic growth to strengthen and sow the seeds of inflation. Step 2: Equity investors catch a whiff of inflation and start to price-in a more restrictive monetary environment. This leads to a stock market correction. Step 3: Falling stock prices and "tightening financial conditions" cause the Fed to downgrade its economic outlook and adopt a more dovish policy stance. Return To Step 1. The Equity Correction For Bond Investors At this juncture, the important question for bond investors is whether financial conditions have tightened enough to prompt a slower pace of rate hikes from the Fed. If so, then it might be appropriate to buy the dip in the bond market. We think such a move would be premature, for two reasons. First, the increase in bond yields that spooked the equity market was concentrated at the long-end of the curve and was fueled by Fed Chairman Powell's comment that the funds rate is "a long way from neutral." A steeper yield curve offsets some of the financial conditions tightening caused by falling stock prices (Chart 3). This is because it signals that monetary policy is becoming more accommodative - the fed funds rate is further below neutral than previously thought. This intuition is confirmed by the bounce in gold, a move that often coincides with an upward rerating of the neutral fed funds rate.2 Chart 3Steeper Curve Will Reassure The Fed Second, the amount of financial market pain that the Fed can tolerate depends on the economic environment. Our Fed Monitor is an indicator that is designed to signal whether the Fed should be hiking or cutting interest rates (Chart 4). It consists of 44 variables that can be grouped into three categories: Chart 4The BCA Fed Monitor Economic growth indicators (Chart 4, panel 3). Inflation indicators (Chart 4, panel 4). Financial conditions indicators (Chart 4, bottom panel). The overall Fed Monitor is currently deep in positive territory, signaling that rate hikes are appropriate. This is true despite the fact that the financial conditions component of the monitor has been falling (tightening) since the beginning of the year. Last week's equity market drop will not be reflected in the indicator until the end of the month, so further downside in the financial conditions component is forthcoming. But so far, tighter financial conditions have barely made a dent in the overall Fed Monitor because they have been offset by rising economic growth and stronger inflation. The conclusion is that the Fed is able to tolerate more market pain when growth is strong and inflation is high. Viewed through this lens, it is clear that a lot more market pain is required before the Fed backs away from its +25 bps per quarter rate hike pace. In fact, the Fed likely views some tightening of financial conditions as desirable, as long as the tightening doesn't severely impede the economic outlook. Just last week New York Fed President John Williams said: Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.3 While a few weeks ago, Fed Governor Lael Brainard noted: The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation.4 In other words, the Fed is increasingly cognizant of the fact that higher interest rates might be necessary to prevent excessive risk-taking in financial markets, even if inflation stays well contained near target. Unless financial conditions tighten so much that they cause the reading from our Fed Monitor to hook down, the Fed will be inclined to view the market correction as healthy. It is also important to note that while a large increase in long-maturity Treasury yields prompted last week's stock market action, the short-end of the yield curve didn't move much at all. In fact, overnight index swap forwards show that the market is just barely priced for three rate hikes during the next 12 months. According to our golden rule of bond investing, if you expect the Fed to lift rates by more than what is priced in for the next 12 months, you should keep portfolio duration low.5 Bottom Line: Last week's equity market sell-off is not enough to prompt the Fed to back away from its +25 bps per quarter rate hike pace. Investors should maintain below-benchmark portfolio duration. On The Correlation Between Yields And Spreads It wasn't just the stock market that struggled to digest higher Treasury yields last week. Corporate bond spreads also widened, particularly in the high-yield credit tiers (Chart 5). As with equities, this is the second time in 2018 that credit spreads widened sharply alongside higher Treasury yields. Chart 5Credit Also Struggling With Higher Rates Credit spreads and Treasury yields tend to be negatively correlated, a feature that benefits bond investors by reducing the volatility in corporate bond yields and total returns. But, as evidenced by last week's price moves, the correlation does occasionally turn positive. This is particularly damaging during sell-offs when both the rate and spread components of corporate bond yields rise. Chart 6 shows the frequency of negative and positive yield/spread correlations since 1994, using 3-month investment horizons. It shows that yields and spreads were negatively correlated in 64% of 3-month periods. Yields fell alongside tighter spreads in 23% of cases, while yields and spreads rose together only 13% of the time. Chart 6The Correlation Between Yields And Spreads Is Typically Negative Since those periods when both yields and spreads rise in unison are particularly damaging for bond investors, it is worth exploring them in more detail. Table 1 lists all 13 quarters since 1994 when junk spreads and duration-matched Treasury yields rose together. Using the logic of our Fed Policy Loop, we also identify three risk factors that might be associated with those periods. The main idea being that yields and spreads are likely to rise together in periods when the market starts to price-in much more restrictive monetary policy, and an earlier end to the economic recovery. The three risk factors we identify are: Table 1Periods When Both Treasury Yields And Junk Spreads Rose Since 1994 Whether the Fed raised interest rates during the investment horizon. Whether our 12-month Fed Funds Discounter increased during the investment horizon, meaning that the market priced-in a more aggressive near-term rate hike path. Whether the 5-year/5-year forward TIPS breakeven inflation rate rose during the investment horizon. Higher long-dated inflation expectations could cause the Fed to respond with a more restrictive monetary policy. The single most important risk factor is whether the Fed raised rates during the investment horizon. Nine of the 13 episodes coincided with a Fed rate hike, and three of the four episodes that didn't coincide with a rate hike occurred between Q2 2013 and Q4 2015. The fed funds rate was pinned at zero during that period, but the Fed was starting to turn hawkish by backing away from QE and preparing for liftoff. This leaves the second quarter of 2007 as the only true outlier. The Fed did not lift rates during this period, but it is clear that markets were spooked by overly restrictive Fed policy all the same. The 2/10 Treasury slope was only 7 bps at the start of the quarter, signaling that monetary policy was already quite restrictive. Meanwhile, long-dated inflation expectations rose during the quarter and the market went from discounting 60 bps of rate cuts during the next 12 months to only 17 bps. An inflationary shock when monetary policy is already restrictive is an environment where yields and spreads are very likely to rise at the same time. An upward move in our 12-month discounter is also associated with periods of rising yields and spreads in 9 out of 13 cases. This risk factor didn't work in Q4 2005 or Q2 2006, but once again it is quite clear that markets were spooked by overly restrictive monetary policy in those periods. The yield curve was inverted in both of those quarters, and the Fed lifted rates despite an inverted yield curve. That combination sends a clear signal to markets that the Fed is trying to choke off the recovery. The 12-month discounter also failed to send the correct signal in Q3 1999 and Q2 2000. In those cases the culprit appears to be a large jump in long-dated inflation expectations while the Fed was in the midst of a rate hike cycle. Since rate hikes should dampen inflation, rising inflation expectations suggest that rate hikes might need to speed up. Thinking about the current environment, we are very much in the danger zone where yields and spreads could rise at the same time. The Fed is in the midst of a rate hike cycle and the market is still not priced for quarterly rate hikes to continue for the next 12 months. Finally, long-dated TIPS breakeven inflation rates are almost back to the 2.3% to 2.5% range that is consistent with "well-anchored" inflation expectations (Chart 7). The higher long-dated breakevens get, the more likely it is that the Fed will respond forcefully to further increases. Chart 7Almost Re-Anchored With all three of our risk factors present, it is highly likely that we will see more episodes where credit spreads widen and Treasury yields rise. The risk will only dissipate once the full extent of the Fed's rate hike cycle is reflected in the Treasury curve, but we are not there yet. While this is not a great environment for bond investors, there are steps investors can take to limit the damage from periods of rising spreads and yields. First, investors should maintain portfolio duration at below-benchmark. Second, while it is too early in the cycle to completely abandon credit, a more defensive posture is advisable. We recommend only a neutral allocation to spread product, focused on the higher-quality credit tiers.6 To the extent possible, investors should also seek to focus their spread exposure at the long-end of the maturity spectrum, while also limiting overall portfolio duration by favoring the short-end of the Treasury curve.7 Inflation Uptrend On Hold Lost in the shuffle amidst last week's market turmoil, the consumer price index (CPI) for September was released and it delivered a soft month-over-month print for the second month in a row. The top panel of Chart 8 shows that the year-over-year trend in core CPI rose rapidly earlier in the year, but now appears to be leveling off. We do not envision a meaningful deceleration in core CPI, but it seems likely that the year-over-year rate of change will stay near current levels for the next six months. Chart 8Core Inflation & Pipeline Pressures Our Pipeline Inflation Indicator remains consistent with rising inflationary pressures in the economy, but it has softened of late. This is mostly due to weaker commodity prices (Chart 8, bottom panel). Further, our Base Effects Indicator - based on rates of change in the core CPI that have already been realized - is now consistent with a lower year-over-year core CPI growth rate six months from now (Chart 9).8 Chart 9Expect Year-Over-Year Core CPI To Flatten-Off, Or Even Decline Looking at the main components of core CPI, the last two monthly prints have been dragged down by the core goods component, with most of the weakness in apparel and used vehicles (Chart 10). This could reverse in the near-term as core goods prices catch up with import prices, which have been rising for some time. However, non-oil import prices have decelerated recently, on the back of a stronger dollar. In other words, any near-term increase in core goods inflation will probably not last very long. Chart 10Core CPI Components The core services excluding shelter component continues to have the most potential upside, since it is highly geared to rising wage growth. Shelter inflation, the largest component of core CPI, has been flat for some time and our models suggest this will continue to be the case for the next six months. Bottom Line: The macroeconomic environment remains highly inflationary. The unemployment rate is very low and wage growth is rising. However, recent trends suggest that the year-over-year growth rate in core CPI will stay close to its current level, near the Fed's target, for the next six months. This will not alter the Fed's "gradual" +25 bps per quarter rate hike pace. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 2 Please see BCA U.S. Bond Strategy Weekly Report, "A Signal From Gold?" dated May 1, 2018, available at usbs.bcaresearch.com. 3https://www.bloomberg.com/news/articles/2018-10-10/williams-says-fed-rate-hikes-helping-curb-financial-risk-taking 4https://www.federalreserve.gov/newsevents/speech/brainard20180912a.htm 5 Please see BCA U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com. 6 Please see BCA U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," dated June 19, 2018, available at usbs.bcaresearch.com. 7 Please see BCA U.S. Bond Strategy Weekly Report, "Out Of Sync," dated July 3, 2018, available at usbs.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges," dated September 4, 2018, available at usbs.bcaresearch.com. 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Special Report

As promised in early September, this is the third installment of our four part Indicators series. In this Special Report, we follow a similar script to Part II but instead of sectors, we now cover the S&P 500, non-financial equities, cyclicals/defensives, small/large and growth/value, and document the most important Indicators in the same four broad categories (where applicable): earnings, financial statement reported data, valuations and technicals. Once again this is by no means exhaustive, but contains a plethora of Indicators we deem significant in aiding us in our decision making process of setting/changing a view on the overall market, cyclicals/defensives portfolio bent, and size and style preference. As a reminder, the charts in this Special Report are also available through BCA's Analytics platform for seamless continual updates. Finally, we are still aiming before the end of 2018, to conclude our Indicators series with Part IV that would feature our most sought after Macro Indicators per the eleven GICS1 S&P 500 sectors, along with value/growth, small/large and cyclicals/defensives. We trust you will find this comprehensive Indicator chartbook useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com S&P 500 Chart 1S&P 500: Earnings Indicators Chart 2S&P 500: Earnings Indicators Chart 3S&P 500: ROE And Its Components Chart 4S&P 500: Financial Statement Indicators Chart 5S&P 500: Financial Statement Indicators Chart 6S&P 500: Valuation Indicators Chart 7S&P 500: Technical Indicators Non-Financial Broad Market Chart 8U.S. Non-Financial Broad Market: ROE And Its Components Chart 9U.S. Non-Financial Broad Market: Financial Statement Indicators Chart 10U.S. Non-Financial Broad Market: Financial Statement Indicators Chart 11U.S. Non-Financial Broad Market: Valuation Indicators Chart 12U.S. Non-Financial Broad Market: Technical Indicators S&P Cyclicals Vs. Defensives Chart 13Cyclicals Vs Defensives: Earnings Indicators Chart 14Cyclicals Vs Defensives: Earnings Indicators Chart 15Cyclicals Vs Defensives: ROE And Its Components Chart 16Cyclicals Vs Defensives: Financial Statement Indicators Chart 17Cyclicals Vs Defensives: Financial Statement Indicators Chart 18Cyclicals Vs Defensives: Valuation Indicators Chart 19Cyclicals Vs Defensives: Technical Indicators S&P 600 Vs. S&P 500 Chart 20S&P 600 Vs.S&P 500: Earnings Indicators Chart 21S&P 600 Vs.S&P 500: Earnings Indicators Chart 22S&P 600 Vs.S&P 500: Valuation Indicators Chart 23S&P 600 Vs.S&P 500: Technical Indicators S&P 500 Growth Vs. Value Chart 24S&P 500 Growth Vs.Value: Earnings Indicators Chart 25S&P 500 Growth Vs.Value: Earnings Indicators Chart 26S&P 500 Growth Vs Value: Valuation Indicators Chart 27S&P 500 Growth Vs.Value: Technical Indicators Table 1S&P 500 Growth/S&P 500 Value Sector Comparison Table Table 2S&P 600/S&P 500 Sector Comparison Table

Highlights Our October house view meeting was mostly uneventful, ... : The backup in bond yields has so far proceeded in line with our expectations, and the BCA consensus is that they have not risen enough to pose a fundamental threat to equities. ... in contrast to the action in global equities: Single-day declines of 3-4% in headline equity indexes around the world gave investors a jolt, and revived the too-far/too-long talk about equity gains with a new intensity. We do not believe that the end of the U.S. equity bull market is at hand, ... : The components of our recession indicator do not suggest that a recession, or a bear market, is on the horizon. It appears that the fiscal stimulus package will keep the expansion going into 2020. ... but thinking through the factors that would lead us to downgrade equities will help put the ongoing data flow into context: In addition to the elements of our bear-market/recession indicator, we consider items that could pressure earnings, spur inflation, or indicate the presence of widespread exuberance. Feature BCA's strategists held their October View Meeting last Tuesday. The monthly meeting gathers all of the editorial staff together to determine the firm's internal consensus on the future direction of markets. The results are published in the form of our House View Matrix, and the discussion and debate of the rationales underpinning our views inform the content of the individual services' publications. The agenda this month focused squarely on interest rates, and consisted of two basic questions: 1) Why are Treasury yields rising, and what does it mean for other asset classes? 2) How worried should we be about the surge in Italian bond yields? Neither question provoked much disagreement. The room broadly agreed that Treasury yields have been rising for the welcome reason that robust U.S. growth calls for higher rates. The Fed has been doing its part at the short end via its gradual quarter-point-per-quarter rate-hike pace, and the bond market got into the act two weeks ago, breaking out to a new seven-year high on robust data releases and Chairman Powell's "long-way-from-neutral" remark (Chart 1). Our bond strategists expect that the Fed will walk back Powell's seemingly off-the-cuff comment, but its substance meshes easily with our assessment of a burgeoning economy that may well overheat in the face of supply constraints. Chart 1Breakout As we have recently argued, the implications for equities depend much more on the level of rates than on their direction. Until real rates begin to squeeze the economy, history suggests that their impact on stocks will be benign. All else equal, higher real rates are a by-product of a stronger economy, and increased economic strength has helped stocks more than the larger haircuts on future cash flows, mandated by a higher discount rate, have hurt them. Using real potential GDP as a proxy for the level at which higher rates would slow the economy, we estimate that the bull market won't meet its demise until the 10-year Treasury yield reaches 3.75-4%.1 Consensus was quickly reached on the Italian question. Although the situation bears close monitoring, BCA does not deem Italy to be a flash point for global financial markets. Our base case is that bond markets can easily handle the deficit back-and-forth between Rome and Brussels, and that the more worrisome outcome - Italy's exit from the Eurozone - is increasingly remote. A bond selloff could become self-perpetuating, but our Global Investment Strategy service believes that European policy makers would intervene if Italian sovereign yields broke above 4%.2 Some strategists expressed interest in downgrading the equity view to underweight. Although a considerable majority voted to maintain BCA's neutral stance, the final stages of the meeting were devoted to debating the merits of a more bearish take. That discussion led us to think about the factors that might encourage us to downgrade our view on equities. The rest of this week's report lays out those factors in the form of an equity-downgrade checklist to accompany the rates checklist we rolled out last month. Together, the two checklists will provide a real-time guide to the evolution of our key asset-allocation views. Our Base-Case Bull-Market Denouement While U.S. Investment Strategy has been slightly more constructive than the BCA consensus, we joined in the house-view downgrade of global equities in June without lament. We did so on the grounds that the latter stages of expansions and bull markets can be treacherous, and significant geopolitical uncertainties could make the current iteration especially so. Last week's swoon, and its remarkable intra-day equity volatility, revealed the wisdom of staying within sight of the shore. We nonetheless believe that it is too early to underweight equities and spread product. We remain constructive on the outlook because we expect the monetary policy cycle, the business cycle, and the credit cycle have yet to run their course. All three will continue to provide an equity tailwind for roughly another year, while allowing spread product to generate excess returns over Treasuries for another quarter or two. Our base case is that the cycles will turn once aggregate demand, ginned up by fiscal stimulus, runs into capacity constraints, stoking inflation pressures and compelling the Fed to impose more restrictive policy settings. Once tight policy is in place, the equity bull market will come to an end, followed by the expansion. The Equity Downgrade Checklist Recessions and bear markets regularly coincide (Chart 2), as multiple de-rating is typically not enough to effect a 20% decline on its own. Earnings have to contract as well, and they typically only do so within the context of a recession. The three components of our recession indicator3 - an inverted yield curve (Chart 3); year-over-year contraction in the index of leading economic indicators (Chart 4); and tight policy, defined as a target fed funds rate greater than the equilibrium fed funds rate (Chart 5) - comprise the first three items on our checklist (Table 1). We round out the recession section by watching for an uptick in the headline unemployment rate, which has led, or coincided with, every postwar recession (Chart 6). Chart 2Bear Markets And Recessions Tend To Coincide Chart 3The Yield Curve Has Called 8 Of The Last 7 Recessions... Chart 4... And So Have Leading Economic Indicators Chart 5Recessions Only Occur When Monetary Policy Is Tight Table 1Equity Downgrade Checklist Chart 6Beware An Uptick In The Unemployment Rate There is more to equity investing than trying to skirt bear markets, however. Our checklist therefore also focuses on elements that could induce corrections (declines of at least 10% that don't reach the 20% bear-market threshold). We focus on three broad categories of variables: those that could pressure earnings growth by undermining revenues, profit margins or both; those that promote uncomfortably high inflation; and those that indicate unsustainable investor over exuberance. We do not have any preconceptions about which, or how many, boxes would have be checked to inspire a downgrade; we are simply trying to obtain a holistic sense of the equity outlook. Earnings Headwinds Employee compensation constitutes the single largest component of corporate expenses, making wage increases a direct threat to profit margins. We view the employment cost index, including benefits, as offering the most comprehensive and accurate insight into companies' wage bill. It has been rising, albeit slowly, and the Fed would like to see it rise even more to ensure that the expansion's gains are shared more broadly across the income spectrum (Chart 7). It would seemingly be happy with wage growth in the mid-3% range, but anything beyond that, if not supported by an uptick in productivity, could lead to faster and/or larger rate hikes.4 Chart 7The Fed Wants Wages Higher, But Not Too Much Higher A stronger dollar makes American goods less competitive in the global marketplace. Extended advances confront U.S.-based multinationals with an unpalatable choice: cut prices to maintain share, or accept lesser share to maintain margins. Currency moves impact corporate profits with a lag, however, so the initial effects of the dollar's 7% advance since mid-February should only begin to surface in the third-quarter earnings season that kicked off on Friday. S&P 500 constituents have been dining out for a year on the dollar's 14% 2017 slide, and a march to 100 and beyond will give rise to a multi-quarter headwind (Chart 8). Chart 8From Tailwind To Headwind Interest accounts for a meaningful share of corporate expenses, especially given the post-crisis rise in corporate debt outstanding. Using BBB-rated bonds as a proxy for overall corporate indebtedness, we view 4.8 to 5%, a level corporations last contended with eight years (and a considerable amount of issuance) ago, as a range that might cause some indigestion (Chart 9). Chart 9Debt Service Costs Are Rising Rising wages squeeze profit margins, but they won't necessarily cut into profits if top-line growth is robust enough to overcome the cost increase. Wage gains have the potential to set off a virtuous circle in which spending increases enough to promote expanded payrolls and capital expenditures, leading to more spending, and so on. An elevated savings rate suggests that households have the capacity to help fuel the fire (Chart 10). If they decide to save that money instead, perhaps with an eye on the metastasizing pile of student debt, it could dampen the multiplier effect of higher wages. Chart 10Plenty Of Dry Powder For Consumption We do not have a hard-and-fast preconception for the point at which deterioration in the emerging markets would be felt in the U.S. Given the relatively closed U.S. economy - the oceans bordering it are big - we expect that the EM distress would have to be quite acute. Full-on decoupling is a chimera, however, even for the fairly insulated U.S., and weakened global demand will eventually make itself felt here. A major credit event or two in some of the larger EM economies would likely accelerate the process. Inflation Now that full employment has been achieved, and then some, the price-stability element of the Fed's mandate will come to the fore as the binding policy constraint. The Fed is still trying to nudge realized inflation and inflation expectations higher, to be sure, but its bias could turn on a dime. Force-feeding sizable fiscal stimulus to an economy already operating at capacity is a recipe for fueling upward inflation pressures. We expect that the Fed will eventually be obliged to hike rates at faster than a gradual pace to get the inflation genie back into the bottle. The Fed's 2% inflation target applies to the core PCE deflator, and growth above the top of the 2.5% range that's held for 20-plus years might make it uneasy if the inflation slope proves to be as slippery as we expect (Chart 11). Regarding inflation expectations, we are keeping a close eye on the long-maturity TIPS break-evens, the expected level of inflation implied by the difference in yields on nominal and inflation-protected Treasuries. Our bond strategists peg 2.3-2.5% as the break-even level consistent with the Fed's 2% inflation target, and expect that the Fed will turn more hawkish if break-evens breach the top end of the range (Chart 12). Inflation matters to the investing public, as well, and earnings multiples would surely contract if inflation fears break out among the general populace. Headline CPI growth that looked like it could persist in the mid-3s could easily spark a correction (Chart 13). Chart 11Mission Impossible(?): Limit Inflation ... Chart 12... While Nudging Inflation Expectations Higher Chart 13CPI Matters, Too Irrational Exuberance It is not easy to recognize over exuberance in real time, but it is a regular feature of cycle peaks. In a bull market that is already the longest in the postwar era, and an expansion that's on track to establish a postwar longevity record of its own, it would be surprising if things didn't ultimately get silly. We will have to rely on judgment to assess the overall climate of recklessness, but we can objectively track valuation levels relative to history. We are not troubled by a 15- or 16-handle forward P/E multiple (Chart 14). While other standard valuation metrics are elevated (Chart 15), they typically only compel our attention at +/- 2-standard-deviation extremes. Chart 14Nothing Irrational About P/E ... Chart 15... Or Other Valuation Metrics, On Balance Investment Implications There is a natural tension between market forecasts and investment strategy. The future is unknowable, and it is rarely prudent to position portfolios all-in based on necessarily uncertain forecasts. The divergence should be especially wide in the latter stages of a cycle, when a reversal could be right around the corner. Even though we are constructive on the economic and policy backdrops, we are positioned conservatively, equal-weighting equities, underweighting fixed income, and overweighting cash. We have created a checklist to track what it would take to make us turn bearish on equities because our inclination is to lean bullish, and try to capture what may be the last outsized returns for a while. Markets are never one-way, however, and we could flip back to overweight upon a 10-15% peak-to-trough decline if nothing altered our view about the bull market's remaining lifespan. We could also return to an equity overweight at current levels if Chinese policymakers were to pursue stimulus with the pedal-to-the-metal urgency that characterized their efforts in 2008 and 2016. We could even try to play a melt-up, with tight stops, if we thought one was about to take hold. We are keeping an open mind, as an investor always should. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the September 24, 2018 U.S. Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?" available at usis.bcaresearch.com. 2 Please see the October 12, 2018 Global Investment Strategy Weekly Report, "Bond Bears Maul Goldilocks," available at gis.bcaresearch.com. 3 Please see the August 13, 2018 U.S. Investment Strategy Special Report, "How Much Longer Can The Equity Bull Market Last?" available at usis.bcaresearch.com. 4 Fed Chair Jay Powell recently said that wage growth should approximately equal the sum of inflation and productivity gains. Given the 2% inflation target, and 1% trend productivity growth, the FOMC would likely be content with wage gains modestly above 3%.

Highlights Rising U.S. bond yields will continue to put downward pressure on global stocks in the near term, but will not trigger an equity bear market until rates reach restrictive territory. We are still at least 12 months away from that point. The blowout in Italian bond yields has further to go, which will also weigh on global risk assets. Nevertheless, we would buy BTPs for a tactical trade if the 10-year yield rose above 4%, because at that level EU policymakers will call out the fire engines. We downgraded global equities from overweight to neutral in June, while maintaining our bias for DM stocks over EM stocks. Barring any major new developments, we would turn bullish again if global stocks were to fall by 8% from current levels. Remain cyclically underweight interest rate duration. We would move to neutral on duration if the U.S. 10-year yield were to rise to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Feature Bond Yields: Up, Up, And Away Global risk assets remained on the back foot this week. The MSCI All-Country World stock market index has now fallen by 6.3% in dollar terms since last Wednesday. Even the mighty S&P 500 has finally buckled under the pressure. The vulnerability of U.S. stocks had been accumulating beneath the surface for some time, as evidenced by the fact that the advance-decline line has been deteriorating since the late summer. The small cap Russell 2000 is down 11.3% from its August 31st highs (Charts 1A& 1B). Chart 1ABreadth Deteriorated In The Lead-Up To The Correction Chart 1BStocks Under Pressure Bond yields usually fall when equities swoon. This time around, it is the increase in bond yields itself that has undermined stocks. In the U.S., yields have risen in response to better-than-expected growth, a wider budget deficit, rising oil prices, and an increasingly hawkish Fed. In Italy, worries about debt sustainability have been the primary driver of rising yields. Neither factor spells doom for global risk assets. However, a period of indigestion is likely over the coming weeks, which could see global equities go down before they go up again. The U.S. Economy: Too Much Winning? We have argued for much of this year that investors were underappreciating the extent to which the Federal Reserve can raise rates without choking off growth. The past few weeks have seen a growing recognition among investors that the Fed may be behind the curve in normalizing monetary policy. This has led to a steepening in the expected path of U.S. short-term rates, which, together with an increase in the term premium, have pushed up yields at the longer-dated maturities. Both better economic data and Fedspeak contributed to the bond sell-off. On the data front, the non-manufacturing ISM index clocked in at 61.6. The all-important employment component of the index hit a record high. Confirming the encouraging labor market signal from the ISM, the unemployment rate fell to a 48-year low of 3.68% in September. While average hourly earnings ticked down to 2.75% on a year-over-year basis, this was entirely due to base effects. On a month-over-month basis, average hourly earnings have risen by 0.3% for three straight months. If this trend continues, the year-over-year rate will rise to 3.2% by the end of this year. Tellingly, recent wage growth has been concentrated among workers at the bottom of the income distribution (Chart 2). This is important because not only do the wages of low-income workers correlate better with labor market slack than those of high-income workers, but low-income workers are also more likely to spend the bulk of their paychecks. Chart 2Wage Growth Has Accelerated At The Bottom Of The Income Distribution Higher wage growth will boost consumer spending. Indeed, it is probable that consumption will rise more than income, given that the personal savings rate has plenty of scope to fall from the current elevated level of 6.6%. Rising wages will incentivize companies to invest more in labor-saving technologies, translating into an increase in capital spending.1 Add in ongoing fiscal stimulus, and we have a recipe for an overheated economy. Starstruck No More As of today, the market has priced in one Fed rate hike in December but only two rate hikes in 2019 (Chart 3). Investors expect no rate hikes in 2020 and beyond. That still seems implausible to us, which suggests that the bond sell-off has further to go. Chart 3The Market Still Thinks The Fed Can't Raise Rates Above 3% In contrast to the past, the Fed no longer seems interested in talking down rate expectations. Speaking with Judy Woodruff at The Atlantic Festival, Chairman Powell stated the Fed "may go past neutral, but we are a long way from neutral at this point, probably."2 Even uber-dove Chicago Fed President Charles Evans appears to have jettisoned his worries about deflation, noting in a speech last Wednesday that "I am more comfortable with the inflation outlook today than I have been for the past several years."3 The Fed has also increasingly downplayed the importance of estimates of the neutral rate of interest, the concept on which the long-term "dots" in the Summary of Economic Projections are based. The Fed's new mantra is that economic data, rather than some theoretical model, should guide monetary policy. Ironically, it was New York Fed President John Williams, who developed one of the most widely used models of r-star, the eponymously named Holston-Laubach-Williams model, that best articulated the Fed's position. At a speech last Monday, Williams argued that the neutral rate of interest, or r-star, has "gotten too much attention in commentary about Fed policy." He went on to say that "Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star."4 Trump And Bonds President Trump was quick to blame the Fed for this week's stock market sell-off. Within the span of 24 hours, he used the words "crazy," "loco," "ridiculous," "too cute," "too aggressive," and "big mistake" to describe recent Fed policy. We doubt Trump's rhetoric will have any immediate effect on Fed decision-making. But even if it did sway the Fed to slow the pace of rate hikes, the result will be higher bond yields, not lower yields. This is simply because any further delays in raising rates will lead to even more overheating, and ultimately, higher inflation and the need for higher rates down the road. Bond Sell-Off Will Produce A Correction In Stocks, Not A Bear Market At the height of this week's bond sell-off, the 10-year Treasury yield breached its 200-month moving average for the first time since ... October 1987 (Chart 4). While that sounds pretty ominous, keep in mind that the 10-year yield had reached almost 10% on the eve of the 1987 stock market crash, or about 6% in real terms. Chart 4Two Lines Meet After Three Decades As my colleague, Doug Peta, discussed two weeks ago, it is the level of interest rates that tends to matter more for stocks rather than the change in rates.5 Specifically, equity returns tend to be lowest at times when monetary policy is already in restrictive territory (Chart 5 and Tables 1 and 2). That was the case in 1987. It is not the case today. Chart 5The Fed Funds Rate Cycle Table 1Tight Policy Is Hazardous To Stocks' Health... Table 2...Especially In Real Terms The fact that stocks do worse in environments where monetary policy is tight makes perfect sense. A restrictive monetary policy is usually a prelude to a recession. As Chart 6 illustrates, bear markets and recessions almost always coincide, with the latter usually leading the former by about six-to-twelve months. None of our favorite leading recession indicators are flashing red now (Chart 7). Even the yield curve has steepened in recent weeks. Chart 6Recessions And Bear Markets Usually Overlap Still, higher long-term bond yields do reduce the long-term attractiveness of stocks compared with bonds. The S&P 500 earnings yield has risen modestly since 2016 due to the fact that earnings have grown somewhat more quickly than equity prices. However, the U.S. real 10-year yield has surged by almost 120 basis points over this period. On balance, this has caused the equity risk premium to decline (Chart 8).6 In order to bring the equity risk premium back down to mid-2016 levels, the S&P 500 would need to fall by about 15% from today's levels. We do not expect stocks to fall by that much, partly because the economic environment is more robust than back then, but a further drop of 5%-to-10% from current levels is certainly plausible. Chart 7A U.S. Recession Is Not Imminent Chart 8Stocks Versus Bonds Italy: Heading For A Debt Crisis? The rise in Treasury yields has reduced the attractiveness of other global government bond markets, causing them to sell off in sympathy. Notably, German bund yields have increased by 33 basis points since their May lows (Chart 9). Chart 9Global Bond Yields Moving Higher Rising German bund yields are bad news for Italy. All things equal, a higher "risk free" bund yield implies a higher Italian bond yield. To make matters worse, as Italian borrowing costs have risen, the perceived likelihood that Italy will be unable to repay its debt has increased. This has caused the spread between German bunds and Italian BTPs to widen, thereby magnifying the effect on Italian bond yields from the increase in risk-free yields. All this has happened at the worst possible moment. Italy's populist government and the European Commission are locked in a battle of wills over next year's budget. The Italian government is targeting a fiscal deficit of 2.4% of GDP for 2019, compared with a deficit of 0.8% that the outgoing caretaker government had proposed in May. Strictly speaking, the new deficit target is still consistent with the 3% limit under the Maastricht Treaty. Nevertheless, it is still causing consternation in Brussels. There are at least three reasons for this: While the government's program has a lot of specifics about how it will increase the deficit - more public investment; a universal minimum income scheme; the ability to retire earlier than under current law; corporate tax cuts; no VAT hike in 2019, etc. - it does not specify which items in the budget will be cut. The program also provides few details on revenue measures, other than proposing a one-off tax amnesty, which will arguably reduce tax receipts over the long haul. The proposed budget assumes real GDP growth of 1.5% in 2019. This is higher than the May projection of 1.4%, and well above the IMF's most recent projection of 1%. The government's real GDP projections for 2020-21 are also about 0.7 percentage points above the IMF's estimates. While Italy's proposed fiscal deficit is below the Maastricht Treaty limit, its current debt-to-GDP ratio of 132% is well above the ceiling of 60% (Chart 10). This implies that Italy should be aiming for a smaller deficit target than what it is currently proposing. Chart 10Italy's Public Debt Mountain We expect the Italian government to ultimately acquiesce to the EU's demands, but not before the bond vigilantes have pushed them into a corner. For their part, the EU establishment would love nothing more than to embarrass the Five Star-Lega coalition in order to send a message to voters across Europe about the dangers of voting for populist parties. This means that the Italian 10-year yield may need to break above 4% - the level at which Italian banks would likely be technically insolvent based on the market value of their BTP holdings - before a compromise is reached. We would put on a tactical trade to buy 10-year BTPs at that level, but not before then. Investment Conclusions Goldilocks will survive, but the next couple of months will be challenging. Our soon-to-be-launched MacroQuant model is signaling a bearish outlook for stocks over the next 30 days (Chart 11). On the bond side, the model currently pegs the fair value for the U.S. 10-year yield at 3.7% (Chart 12). Bond sentiment is quite bearish at the moment, which makes a brief countertrend bond rally quite likely. However, the cyclical trend in yields remains to the upside. Chart 11MacroQuant* Recommends That Caution Is Warranted Towards Equities Chart 12MacroQuant Sees 10-Year Treasury Yields Still Below Fair Value We stated last week that investors should consider scaling back risk if they are currently overweight risk assets. We continue to favor this more cautious stance. For the first time in over a decade, short-term U.S. rates are above the dividend yield on the S&P 500 (Chart 13). Holding a bit more cash is finally an attractive option, at least for U.S.-based investors. Chart 13Cash Anyone? If the sell-off in global equities continues, it will present a buying opportunity, given that the next major global economic downturn is probably at least another two years away. Barring any major new developments, we would turn bullish on stocks again if the MSCI All-Country World Index were to fall by 12% 10% 8% from current levels.7 We would recommend that investors move from an underweight to a neutral interest rate duration position in global bond portfolios if the U.S. 10-year Treasury yield rose to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 It is true that additional investment spending will raise aggregate supply, but normally it takes a while for that to happen. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see "WATCH: Powell says Fed is focused on 'controlling the controllable,' not politics," PBS News Hour, October 3, 2018; and Jeff Cox, "Powell says we're 'a long way' from neutral on interest rates, indicating more hike are coming," CNBC, October 3, 2018. 3 Charles Evans, "Monetary Policy 2.0?" OMFIF City Lecture on the U.S. Economic Outlook, London, England, October 3, 2018. 4 John C. Williams, "Remarks at the 42nd Annual Central Banking Seminar," Bank for International Settlements, October 1, 2018. 5 Please see U.S. Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?" dated September 24, 2018; and Special Report, "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018. 6 For this exercise, we define the equity risk premium as the difference between the S&P 500 earnings yield (the inverse of the forward P/E ratio) and the real 10-year bond yield (using CPI swaps as our measure of expected inflation). 7 The perils of writing a report during a week when markets are moving fast. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades