Sectors

​​​​​​​ Overweight In Monday’s Cyclical Indicator Update, we highlight our cyclical portfolio bent, driven by three core catalysts that we think will take U.S. equities higher. These are: a definitively more dovish Fed, which would help restrain the greenback, a continuation of the earnings juggernaut and a positive U.S./China trade resolution. One cyclical sector that looks particularly attractive is S&P financials. The divergence between the directions for our cyclical macro indicator (CMI) and our valuation indicator (VI) for financials has reached stunning levels. The CMI is accelerating into pre-GFC territory as credit quality, loan growth and unemployment are all in the sweet spot while the VI has fallen to two standard deviations below fair value. Our technical indicator (TI) sends a signal that financials are modestly oversold though this relatively neutral message does not diminish the most bullish signal in our cyclical indicator’s history. Bottom Line: We reiterate our overweight recommendation for S&P financials. Please see Monday’s Cyclical Indicator Update for more details on this as well as our cyclical indicator updates on the other GICS1 sectors and our large cap/small cap style preference.

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

Overweight In a recent Weekly Report,1 we highlighted four reasons to stay overweight banks that more than counter the risk of a 10/2 yield curve inversion. These are: vibrant and broad-based bank credit growth, pristine credit quality, pent up bank buyback demand and a V-shaped recovery in bank ROE. Further, despite the headwind a flat yield curve represents to net interest margins, ultra low deposit rates provide a healthy margin offset (bottom panel). Yesterday gave us a fifth reason to remain overweight banks; a looming consolidation phase of the multitudinous smaller regional banks. BB&T Corp. announced it was buying SunTrust Banks Inc. in a deal valued at about $66 billion to create a firm with approximately $442 billion in assets, making it the sixth-largest U.S. bank. Unusually, both stocks rallied on this merger announcement which should send a confirming message to other regional players that increased scale to compete with much larger peers will be welcomed by shareholders. Bottom Line: Investors should cheer the return of M&A premia to this still-discounted sector, particularly when returns on equity are soaring (second panel). Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC,. Footnotes 1      Please see BCA U.S. Equity Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com.  

​​​​​​Overweight Since our upgrade to overweight mid-last month,1 steel stocks have been outperforming as operating metrics have continued to fire on all cylinders. New orders have been soaring in the past two years as end demand has proven exceptionally resilient and the new orders/inventories ratio clearly demonstrates the industry’s struggles to keep pace with the market’s demand for their products (second panel). The resulting increase in activity has pushed industry capacity utilization to post-GFC highs (third panel). With solid demand in place and constrained capacity, a firm pricing environment seems assured and the focus turns to costs. On that front, the news is equally encouraging; iron ore prices have been modestly rising for much of the past four years but are at levels nearly half those of the previous period (bottom panel). Net, the earnings outlook for steel stocks stands on exceptionally positive footing; stay overweight. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL – NUE, STLD, RS, X, ATI, CMC, CRS, WOR, AKS, SXC, TMST, HAYN and ZEUS.   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com.

Underweight (High-Conviction) The S&P interactive media & services index’s heavyweights Alphabet (the parent of Google) and Facebook have now reported their Q4 results and, while both beat estimates (particularly soundly in the case of Facebook), slowing profit growth remains the dominant theme. Both highlighted strong top line efforts for the year to come but equally, both reported costs growing faster than the top line. This is reflected in forward EPS growth estimates (second panel) which have now retreated to the same pace as the broad market. However, sector valuations responded by rising and the gap versus the broad market has started widening (bottom panel). While superior growth should be rewarded with rich valuations, this no longer seems appropriate for this sector. Tack on the ever-present risk of increasing regulation, which we think will be a key sector headwind this year, and a discount seems much more appropriate. Bottom Line: Heady valuations are prone to a downfall and the S&P interactive media & services index has more than its fair share of negative catalysts; stay underweight.   The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP.

Highlights Chart 1Look For Rate Hikes In H2 2019 First things first: The Fed’s rate hike cycle is not over. Last week’s FOMC statement told us that the Fed will be “patient” and Chairman Powell cited slower global growth and tighter financial conditions as reasons to keep the funds rate steady. However, both of those reasons could soon evaporate. With the market now priced for 8 bps of rate cuts during the next 12 months and the dollar off its highs, there is scope for financial conditions to ease and global growth to improve in the first half of the year. According to our Fed Monitor, only tight financial conditions warrant a pause in rate hikes (Chart 1). The economic growth and inflation components of our Monitor (not shown) continue to recommend a tighter policy stance. The message is that if risk assets rally during the next six months causing financial conditions to ease, then all else equal, the Fed will have the green light to re-start rate hikes in the second half of the year. Investors should maintain below-benchmark duration in U.S. bond portfolios. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 183 basis points in January. The index option-adjusted spread tightened 25 bps on the month and currently sits at 127 bps. We upgraded our recommended allocation to corporate bonds three weeks ago because spreads had become too wide given the current phase of the credit cycle.1 Presently, we observe that the 12-month breakeven spread for Baa-rated corporate bonds has been tighter 43% of the time since 1989 (Chart 2). In the phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps, corporate breakeven spreads are typically in the lower third of their distributions.2 Chart 2Investment Grade Market Overview Baa-rated bonds currently offer better value than higher-rated credits. The 12-month breakeven spread for A-rated debt has been tighter 29% of the time since 1989 (panel 2). Aa and Aaa-rated credits clock in at 25% and 4%, respectively. With the Fed in a holding pattern, we are comfortable taking credit risk for the next six months and recommend that investors move down in quality to capture the extra return. The Fed’s Q4 Senior Loan Officer Survey, released yesterday, showed that a net 3% of banks reported tightening lending standards on C&I loans. Tighter lending standards correlate with higher defaults and wider spreads, so this tentative development bears close monitoring going forward.   High-Yield: Overweight High-yield outperformed the duration-equivalent Treasury index by 408 basis points in January. The index option-adjusted spread tightened 103 bps, and currently sits at 416 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 224 bps, slightly below the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast for the next 12 months, high-yield bonds will return 224 bps in excess of duration-matched Treasuries, assuming no change in spreads. Chart 3High-Yield Market Overview Moody’s revised its baseline 12-month default rate forecast higher last month, from 2.6% to 3.4%, and as was discussed in last week’s report, the revised forecast looks reasonable given our economic outlook.3 Specifically, our measure of nonfinancial corporate sector gross leverage – calculated as total debt over pre-tax profits – is roughly consistent with a 4% default rate. This leverage measure improved rapidly during the past year, but should start to stabilize during the next few quarters as profit growth decelerates. All in all, baseline default rate expectations have moved higher in recent months, but junk spreads still offer adequate compensation for that risk. In fact, if we assume excess compensation equal to the historical average, then junk spreads embed an expected default rate of 3% (panel 4), not far from the Moody’s base case. While junk spreads offer adequate compensation given our 12-month default outlook, the near-term outlook for excess returns is somewhat brighter as the Fed’s dovish turn should lead to spread compression during the next few months. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The conventional 30-year zero-volatility spread tightened 3 bps on the month, driven by a 3 bps decline in the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The drop in the 30-year mortgage rate to 4.46%, from 4.94% in November, led to a sharp spike in mortgage refinancings. However, refi activity remains very low relative to history (Chart 4). With the longer-run uptrend in mortgage rates still intact, the recent spike in refinancings is bound to reverse in the coming months. This will keep MBS spreads capped near historically low levels. Chart 4MBS Market Overview Outside of refi activity, MBS spreads are also influenced by changes in mortgage lending standards. The Federal Reserve’s Senior Loan Officer Survey showed no change in residential mortgage lending standards in Q4 2018 (bottom panel), while reported mortgage demand took a significant dip. Periods of tightening lending standards tend to coincide with MBS spread widening, but faced with weaker demand banks are much more likely to ease standards going forward. This is particularly true because very little progress has been made easing lending standards since the financial crisis. The median FICO score for new mortgages peaked at 781 in Q1 2011, but had only fallen to 758 as of Q3 2018. With relatively little risk of spread widening we are comfortable with a neutral allocation to Agency MBS, though tight spreads make the sector less appealing than corporate bonds from a return perspective. Later in the cycle, when the risk of corporate spread widening is more pronounced, MBS will likely warrant an upgrade. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 53 basis points in January. Sovereign debt led the way, outperforming the Treasury benchmark by 221 bps. Foreign Agencies outperformed by 65 bps, Local Authorities outperformed by 32 bps, and Supranationals outperformed by 3 bps. Domestic Agency bonds were the sole laggard, underperforming Treasuries by 3 bps on the month. The Fed’s pause and the accompanying weakness in the dollar spurred last month’s outperformance of USD-denominated Sovereign debt. But given the current attractiveness of U.S. corporate credit, we are not eager to chase the outperformance in Sovereigns. The option-adjusted spread advantage in Baa-rated U.S. corporate credit relative to the Sovereign index is as wide as it was in mid-2016 (Chart 5), a period when corporate bonds outperformed Sovereigns by a significant margin. Chart 5Government-Related Market Overview At the country level, our analysis of USD-denominated Emerging Market Sovereign spreads shows that only Argentina, Mexico, Saudi Arabia, Qatar, UAE and Poland offer excess spread compared to equivalently-rated U.S. corporates.4 We continue to view the Local Authority sector as very attractive. The sector offers similar value to Aa/A-rated corporate debt on a breakeven spread basis (bottom panel), and it is also dominated by taxable municipal securities that are insulated from weak foreign economic growth. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 7 basis points in January (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 2% in January, and currently sits at 84% (Chart 6). This is about one standard deviation below its post-crisis mean but above the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and +50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of -14 bps. In contrast, municipal bonds have delivered annualized excess returns of +47 bps (before adjusting for the tax advantage).5  Given strong historical returns during the current phase of the cycle and the fact that our Municipal Health Monitor remains in “improving health” territory (bottom panel), we advocate an overweight allocation to municipal bonds. Long maturity municipal debt continues to offer a substantial yield advantage relative to the short-end of the curve. For example, a muni investor needs an effective tax rate of 35% to equalize the after-tax yields between a 5-year Aa-rated municipal bond and the equivalent-duration U.S. credit index. For a 20-year muni the same breakeven tax rate is between 10% and 17%. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields declined in January, with the 5-year and 7-year maturities falling more than the short and long ends of the curve. The 2/10 slope flattened 3 bps on the month, from 21 bps to 18 bps. The 5/30 slope steepened 5 bps on the month, from 51 bps to 56 bps. In a recent report we looked at the correlations between different yield curve slopes and our 12-month Fed Funds Discounter.6 We found that the 5-year and 7-year maturities are most sensitive to changes in the discounter, while the short and long ends of the curve tend to be more stable. In other words, a decline in our 12-month discounter, like the one seen during the past two months (Chart 7), will tend to flatten the curve out to the 5-year/7-year maturity point and steepen the curve beyond that point. An increase in the discounter has the opposite effect. Chart 7Treasury Yield Curve Overview We expect the market to price some Fed rate hikes back into the curve as financial conditions ease during the next few months. Based on that view, we recommend adopting a yield curve strategy that benefits from a rise in our 12-month discounter. A position short the 7-year bullet and long a duration-matched 2/30 barbell provides the appropriate exposure and is attractively valued by our yield curve models (panel 4).7 TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 84 basis points in January. The 10-year TIPS breakeven inflation rate rose 14 bps on the month, and currently sits at 1.88%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps, and currently sits at 2.04%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. The 10-year TIPS breakeven inflation rate also remains below the fair value reading from our Adaptive Expectations Model (Chart 8).8 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value reading will trend steadily higher as long as core CPI inflation remains above 1.83%. The 1.83% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in our model.   Chart 8Inflation Compensation On that note, core CPI has increased at an annual rate of 2.48% during the past 3 months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 4), this is largely a reaction to the recent drop in energy prices. A drop that should reverse as global growth improves in the coming months. ABS: Neutral Asset-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 8 bps on the month, and currently sits at 40 bps, 6 bps above its pre-crisis low. The Excess Return Bond Map in Appendix C shows that consumer ABS offer greater expected return than Domestic Agencies and Supranationals, though with a commensurate increase in risk. The Map also shows that Agency CMBS offer very similar return potential with much less risk. The Fed's Senior Loan Officer Survey for Q4 2018 showed that banks tightened lending standards slightly for both credit cards and auto loans. This is consistent with a continued gradual uptrend in consumer credit delinquencies (Chart 9). Chart 9ABS Market Overview Rising household interest expense further confirms that the consumer credit delinquency rate is biased higher, albeit from a low starting point (panel 4). All in all, ABS still offer a reasonable risk/reward trade-off but could warrant a downgrade in the coming quarters as credit quality worsens. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 67 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 11 bps on the month and currently sits at 105 bps. The Fed’s Senior Loan Officer Survey showed that banks tightened lending standards on commercial real estate (CRE) loans in Q4 and witnessed falling demand (Chart 10). This is a typical negative environment for CMBS spreads. Decelerating CRE prices are also a cause for concern (panel 3). Investors should maintain an underweight allocation to non-Agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The index option-adjusted spread tightened 4 bps on the month and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector continues to make sense. Chart 10CMBS Market Overview Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 8 basis points of rate cuts during the next 12 months. Given that we expect the Fed to deliver rate hikes in the second half of this year, we recommend that investors maintain below-benchmark portfolio duration. Appendix B- Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury yield curve. The models are explained in detail in the following two Special Reports: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of January 31, 2019)   Table 5Butterfly Strategy Valuation: Standardized Residuals (As of January 31, 2019)   Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 2 For further details on how we divide the credit cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Oil Supply Shock Is A Risk For Junk”, dated October 9, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearh 6 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 7 The output from all of our yield curve models is shown in Appendix B of this report. 8 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation