Developed Countries

Highlights Duration: The current strength of the U.S. economy suggests that, as was the case in February, the sell-off in risk assets may not result in much of a drop in Treasury yields. Weak foreign economic growth still presents a risk, but it should be hedged by adopting a more defensive stance on credit, not by increasing portfolio duration. Corporate Bonds: Weak foreign economic growth will impact U.S. corporate profits and investment spending before hitting U.S. consumer spending and overall GDP. This means it is better to hedge the risk from weak foreign growth by scaling back exposure to corporate bonds, while maintaining below-benchmark duration. Credit Curve: Favoring the long-end of the credit curve is a way to increase the average spread of a bond portfolio without taking on extra credit risk. Rather, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. In the current environment we prefer going after the extra spread at the long-end of the credit curve, while maintaining an up-in-quality bias and only a neutral allocation to corporate bonds. Feature We're not out of the woods yet. Risk assets continued their decline last week, the VIX remains elevated and the 10-year yield has fallen off its highs (Chart 1). In the context of our Fed Policy Loop, lower bond yields are a positive sign for risk assets. Chart 1How Much Worse Will It Get? In our Fed Policy Loop framework, higher yields and the perception of increasingly hawkish Fed policy cause credit spreads to widen and stock prices to fall. Then, tighter financial conditions eventually lead to perceptions of more dovish Fed policy and lower bond yields. At some point, yields fall far enough to put a floor under risk assets (Chart 2). Chart 2The Fed Policy Loop We are now at the stage of the loop where we must determine how large a decline in Treasury yields will be necessary to halt the slide in risk assets. To make that determination, it is helpful to think about why risk assets are falling. Is it a simple correction driven by investors re-assessing appropriate valuations? Or is the market sniffing out a future slowdown in economic growth? Chart 3 shows why the difference is meaningful. In February 2018, a sharp increase in Treasury yields caused the stock-to-bond total return ratio to decline. However, the ratio quickly recovered once investor sentiment toward the stock market became somewhat less bullish. Importantly, Treasury yields did not need to fall to support a rebound in risk assets, they only needed to level-off for a time. Chart 3Lower Yields Required? In contrast, a meaningful decline in Treasury yields was required to arrest the drop in the stock-bond ratio that occurred in late-2015/early-2016. The difference between that period and the February 2018 period is obvious. In late-2015/early-2016, the U.S. Manufacturing PMI had just dipped below the 50 boom/bust line. This year the PMI has been closer to 60 (Chart 3, bottom panel). The current strength of the U.S. economy suggests that, as was the case in February, the sell-off in risk assets may not result in much of a drop in Treasury yields. With the market only priced for 54 bps of rate hikes during the next 12 months, and no signs of softening in the U.S. economic data, we are reluctant to abandon our cyclical below-benchmark portfolio duration stance at this time. That is not to say there are no risks on the horizon. In past reports we flagged the risk that slowing foreign economic growth will eventually impact the U.S. economy, causing it to slow as we head into next year.1 However, we think it makes more sense to hedge this risk by adopting a more defensive allocation to corporate credit versus Treasuries, rather than by shifting portfolio duration to look for lower yields. Hedge Economic Risk In Credit, Not Duration As was stated above, U.S. economic growth remains strong and the biggest risk on the horizon is that weak foreign growth eventually migrates stateside via a stronger dollar. Last week's third quarter GDP report confirmed that overall growth is solid, but also showed some evidence of weak foreign growth impacting the U.S. figures. Overall, real GDP grew by a healthy 3.5% (annualized) in the third quarter, supported mostly by consumer spending which contributed 2.7% to overall growth, the most since Q4 2014 (Chart 4). However, weakness was found in nonresidential investment spending which contributed only 0.1% to real growth, down from 1.2% in the prior quarter (Chart 4, bottom panel). Chart 4Parallels With Early 2015 This distribution of growth between consumer spending and investment is identical to what occurred in 2015, the last time that weak foreign growth infiltrated the U.S. economy. The more globally-exposed investment sector contributed almost nothing to growth in the first two quarters of 2015, while overall GDP growth stayed elevated, driven by strong consumer spending. Eventually, consumer spending also weakened and GDP growth plunged in the second half of the year, but the warning sign that weak foreign growth was negatively impacting the U.S. economy came from investment spending in the first half of 2015. We draw the distinction between U.S. investment spending and U.S. consumer spending for two reasons. The first is that investment spending is more influenced by global factors than the U.S. consumer. The second is that investment spending is tightly linked to corporate profit growth (Chart 5). In other words, weak foreign economic growth is likely to negatively impact U.S. corporate profits before it hits overall U.S. GDP. This makes credit spreads more exposed to global weakness than Treasury yields, which take their cues from overall GDP growth. Chart 5Investment Spending And Profits Are Linked While we think that weak foreign growth will weigh on corporate profits in the coming quarters, presenting a clear negative for corporate bond spreads. We must also consider that spread widening during the past two weeks means that valuation has improved. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses now stands at 274 bps, up from 212 bps a month ago and slightly above the historical average (Chart 6). However, we must also point out that our calculation embeds expected default losses of only 1.04% for the next 12 months. This low default loss expectation, which is derived from Moody's baseline default rate forecast and our own forecast of the recovery rate, means that there is a high risk that default losses surprise investors to the upside during the next 12 months (Chart 6, bottom panel). Any moderation in profit growth would make such an upside surprise even more likely. Chart 6Junk Value Has Improved... Another way to think about our default-adjusted high-yield spread is that if we assume that default losses occur in line with our forecast and that junk spreads remain flat at current levels, then junk bonds will outperform duration-matched Treasuries by 274 bps during the next 12 months. If spreads tighten by enough to bring the default-adjusted spread back to its historical average of 247 bps, then junk will outperform duration-matched Treasuries by 380 bps. However, at the current juncture we are more worried about spread widening during the next 6-12 months than spread tightening. Chart 7 shows that junk spreads tend to predict changes in capacity utilization. At current spread levels, this means we should expect capacity utilization to rise back to the 80% level during the next six months. If weak foreign economic growth starts to weigh on U.S. corporate profits, then such a large gain is very much in doubt (Chart 7, bottom panel). Chart 7...But Spreads Embed Strong IP Growth Bottom Line: Weak foreign economic growth will impact U.S. corporate profits and investment spending before hitting U.S. consumer spending and overall GDP. This means it is better to hedge the risk from weak foreign growth by scaling back exposure to corporate bonds, while maintaining below-benchmark duration. Extend Maturity In Credit, Not Treasuries Given the risk to corporate profits that is posed by weak foreign economic growth, we recommend investors maintain only a neutral allocation to corporate bonds and also maintain an up-in-quality bias across credit tiers.2 In the current environment we think the best way to pick-up spread within a neutral allocation to corporate bonds is to favor the long-end of the maturity spectrum. This will need to be offset by maintaining very low duration within your Treasury allocation to ensure that overall portfolio duration stays below benchmark. The rationale for favoring the long-end of the corporate credit curve is twofold. First, there is extra spread available at the long-end of the credit curve compared to the short-end. In fact, the long-maturity investment grade corporate bond index carries an average option-adjusted spread that is 107 bps greater than that of the intermediate-maturity index (Chart 8). Second, the extra spread available at the long-end of the credit curve is purely compensation for the extra duration risk. The bottom panel of Chart 8 shows that there is no spread advantage at the long-end on a "per unit of duration" basis. Chart 8Favor The Long-End Of The Corporate Credit Curve The fact that the extra spread at the long-end of the credit curve is purely compensation for duration is important because it means that when Treasury yields rise and average index duration falls, investors should demand less compensation for the extra duration risk at the long-end of the curve. In other words, rising Treasury yield environments should coincide with spread compression at the long-end of the credit curve versus the short end. We tested this idea empirically by looking at monthly excess returns in long-maturity corporate bonds versus short-maturity corporate bonds. Using a sample of monthly returns going back to 2000, we divide the months based on whether the Treasury curve bear-steepened, bear-flattened, bull-steepened or bull-flattened (Table 1). The results show that while changes in the slope of the yield curve don't have much impact, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. Table 1Monthly Excess Return In Long Maturity Vs. Short Maturity Corporate Bonds (2000-Present) Bottom Line: Favoring the long-end of the credit curve is a way to increase the average spread of a bond portfolio without taking on extra credit risk. Rather, the long-end of the credit curve outperforms when Treasury yields rise and underperforms when they fall. In the current environment we prefer going after the extra spread at the long-end of the credit curve, while maintaining an up-in-quality bias and only a neutral allocation to corporate bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The latter stages of expansions and bull markets ought to be jittery, ... : Equities tend to get jumpier in the final stages of equity bull markets, but performance typically improves enough to generate attractive risk-adjusted returns. ... and tariff fights, a potential trade war, and other daunting headlines only make things worse: Tariff worries are starting to pile up in earnings calls, threatening financial markets and the real economy. When it comes to the economy, U.S. investors have to ask how much good news is too much good news: The trouble with an extended stretch of good news is that it conditions investors to keep setting the bar higher. After all, bear markets don't begin when things are bad, they begin when things can't get better. We remain constructive on risk assets, but we recognize the need for vigilance: The indicators we're watching are not signaling a turn right now, but we are keeping our eyes peeled. Feature So much for the boring bull market. After a somnolent 2017, when single-day moves of at least 1% were a rarity, and there were no 2% moves at all, volatility is back (Chart 1). The S&P 500 shed 9% in the three weeks ended Wednesday; the major small-cap indexes and the NASDAQ have fared a good bit worse; and with the vast majority of S&P 500 constituents having made corrections (peak-to-trough declines of at least 10%), breadth is crumbling. The key question for asset allocators and equity investors of all stripes is whether or not the recent moves mark the beginning of a bear market. Chart 1What A Difference A Year Makes We do not think they do; volatility is supposed to reawaken in the latter stages of bull markets, and we are not deterred by October's admittedly lousy action. Our work on the key cycles does not point to an imminent inflection point, and we still think the bull market has another year to go. We are conscious of the dangers of being lulled to sleep by a strong U.S. economy, but we take some comfort from a review of the way bull markets have played out over the last 50 years. A preponderance of evidence suggests that the expansion, the credit cycle, and the equity bull market are not over yet, and we recommend staying invested. The Evolution Of Bull Markets The bull market that began in March 2009 is the ninth bull market of the last 52 years.1 Bull markets have been the rule, with the S&P 500 spending less than 20% of that stretch in a bear market (Chart 2). We have previously noted that large-cap U.S. bull markets have a tendency to sprint to the finish line; the pace of appreciation tends to quicken noticeably over a bull's final stages. Chart 2Bull Markets May Be Stocks' Natural Condition ... Charts 3 and 4 present the course of bull-market gains from 1966 through 2007. Details of the bull markets, which span nearly 8,400 sessions, are listed in Table 1. Each quintile in Chart 3 reflects the aggregate performance over the eight complete bull markets between 1966 and 2007; the first quintile's performance is calculated by linking the advance in the first 104 days of Bull #1, with the advance over the first 133 days of Bull #2, the advance over the first 311 days of Bull #3, and so on through the first 252 days of Bull #8, summing to eight advances across 1,679 trading days. Decile calculations follow the same protocol, aggregating 839 or 840 days of performance. Chart 3... But Performance Within A Bull ... Chart 4... Is Quite Variable Table 1S&P 500 Bull Markets Since 1966 The return distributions are quite uneven, with only the first and last deciles clearly topping the aggregate bull-market return. Investors who underweight equities before the bull market is complete are at risk of underperforming their benchmarks. Investors who are underweight equities when the bull market commences are almost certain to underperform. Bull markets may quicken in their final stages, but they begin by being shot out of a cannon. The cannon shot may offer an important takeaway about equity positioning in bear markets, but we will take the inflections one at a time. The key U.S. equity decision currently confronting an investor is whether or not attempting to capture the final gains in this bull market is worth his/her while. Per historical annualized mean returns and standard deviations in each bull-market decile, the risk/reward profile favors remaining fully invested (Chart 5, top panel). The first and last deciles lead the way on a return-per-unit-of-risk basis just as surely as they do on an absolute-return basis (Chart 5, bottom panel). Chart 5Bulls Also Sprint To The Finish Line On A Risk-Adjusted Basis Bottom Line: The lion's share of bull-market gains are earned in their first and last deciles, on both an absolute and a risk-adjusted basis. If the bull market has another year to run, history favors maintaining at least an equal weighting in equities in spite of the recent upheaval. What Might Be Different This Time There is no shortage of factors to worry about right now. The tit-for-tat imposition of new tariff barriers is likely to exert at least some downward margin pressure for all companies that export goods to China, and/or consume resources/sell imported goods subject to tariffs. Tariffs are beginning to be cited regularly as a burden on quarterly earnings calls. Our geopolitical strategists don't expect the issue to go away any time soon; they view the trade contretemps as just one element of a struggle for preeminence between the U.S. and China. Pressure from a stronger dollar is also being blamed for lowered earnings forecasts. Comments from reliably dovish Atlanta Fed President Bostic confirmed that the FOMC is viewing developments through a more hawkish lens. Price stability is the focus at the Fed, as one should expect with the unemployment rate at a 50-year low and headed lower.2 There is more to exchange rates than policy-rate differentials, but the rising fed funds rate will keep at least some wind at the dollar's back. We do not expect that the president's ongoing attempts to discourage the Fed from continuing to hike will amount to anything. White House pressure on the Fed is nothing new, from LBJ's inimitable face-to-face negotiating style, to Nixon's (successful) campaign to influence Arthur Burns, to George H.W. Bush's testy public inveighing against rate hikes early in his term. Just last week, Paul Volcker divulged a remarkable joint effort by President Reagan and Treasury Secretary Baker to get the Fed to stay its hand ahead of the 1984 election. As Reagan looked on silently, according to Volcker, Baker told him, "The president is ordering you not to raise interest rates before the election."3 The news that devices resembling functional pipe bombs had been mailed to several Democratic officials, including former president Obama and the Clintons, helped to unsettle markets last Wednesday. Trade matters more to financial markets, however. For all the dispiriting headlines, it remains our view that the expansion remains healthy and is likely to continue for another year, backed by double-barreled fiscal and monetary accommodation. We are monitoring trade tensions and the dollar, but we don't yet see a catalyst to precipitate an inflection point in the key cycles. How To Fool A Macro Investor Even if the domestic economy is hale and hearty, however, investors can't blithely ignore the risks. The latter stages of expansions and bull markets can be treacherous. We know of no one who has articulated the market perils of good times as well as Oaktree Capital co-founder Howard Marks. Inspired by a client, we read all of Marks' client memos from 20074 at the beginning of the year, and we have been mulling over his concerns about the current cycle as he's raised them. Although we are not concerned about current valuation levels, the S&P 500 isn't cheap. We are encouraged that the forward earnings multiple is nearly three points off of its year-to-date high (Chart 6), but other metrics are at least somewhat elevated relative to history (Chart 7). We only get exercised about valuation at extremes, and we long ago internalized the law of mutual exclusivity: investors can have cheap stocks or good news, but they can't have both. Given the relentless drumbeat of good economic and corporate earnings news, stocks shouldn't be cheap. Chart 6Valuations Have Cooled Considerably Since January ... Chart 7... Across The Board There is a fine line between good and too good, however, because growth in mature companies and economies ultimately reverts to the mean. When expectations get too high, investors run the risk of finding themselves offside, as Marks has written: No matter how favorable and steady fundamentals may be, the markets will always be subject to substantial cyclical fluctuation. The reason is simple: even ideal conditions can become overrated and therefore overpriced. And having reached too-high levels, prices will correct, bringing capital losses despite the idealness of the environment [.] So don't fall into the trap of thinking that good fundamentals = positive market outlook [.] ... [P]rofit potential is all a matter of the relationship between intrinsic value and price. There is no level of fundamentals that can't become overpriced.5 Investment Implications We remain constructive on the economy and markets, because we do not see a near-term catalyst to cut off the expansion, the credit cycle and/or the equity bull market. Significant equity market downturns typically require outright contractions in corporate earnings (contractions, not decelerating growth, which has historically been just fine for stocks), and they rarely occur outside of recessions. Our simple recession indicator, which looks at the slope of the yield curve, the year-over-year change in leading economic indicators, and the state of Fed policy, is nowhere near danger territory.6 There is no doubt that complacent investors could get too bulled up on already-discounted good news, but fiscal stimulus would seem to ensure that a recession is out of the question in 2019. The fraught environment pushed us to cut our house view on global equities from overweight to equal weight at our June View Meeting, redirecting the proceeds to establish a cash overweight. U.S. Investment Strategy followed suit, pulling in its horns on U.S. equities. The downgrade has paid off; as of Thursday's close, the MSCI All-Country World Index had fallen 7% since June 15th, while the S&P 500 was down 2.7%. As we mentioned last week, the 2,600-2,640 range, spanning correction territory to the year-to-date lows (Chart 8), looks pretty good to us and we will look to increase our recommended equity exposure if the S&P approaches its lower bound. Chart 8The Sell-Off May Nearly Be Spent Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 We adhere to the classic definition of bull (and bear) markets, a trough-to-peak closing-price gain (peak-to-trough decline) of at least 20%. 2 According to the Atlanta Fed's online calculator (https://www.frbatlanta.org/chcs/calculator.aspx?panel=1), it takes less than 110,000 monthly payroll gains to keep the unemployment rate at a steady state. 3 "Paul Volcker, at 91, 'Sees a Hell of a Mess in Every Direction,' New York Times. Accessed October 23, 2018. https://www.nytimes.com/2018/10/23/business/dealbook/paul-volcker-federal-reserve.html 4 Marks' memos are available to the public at https://www.oaktreecapital.com/insights/howard-marks-memos. 5 Marks, Howard, "It's All Good," July 16, 2007 Memo to Oaktree Clients, p.5. Accessed from online archive February 18, 2018. 6 Please see the August 13, 2018 U.S. Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com.