Developed Countries

Highlights Duration: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. High-Yield: A supply shock in the oil market would most likely lead to steep backwardation in the oil 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. Emerging Market Sovereigns: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Feature Bond Breakout Chart 1The Long End Breaks Out Bond markets sold off sharply last week and long-dated Treasury yields took out some noteworthy technical levels in the process. The 10-year Treasury yield broke above its May 2018 peak of 3.11% and settled at 3.23% as of last Friday. The next big test for the 10-year's cyclical uptrend is the 2011 peak of 3.75% (Chart 1). The 30-year yield similarly broke above its May 2018 peak of 3.25%, settling at 3.39% as of last Friday. The next resistance for the 30-year occurs at the early-2014 peak of 3.96%. Removing our, admittedly uncomfortable, technical analysis hat, it is instructive to note which macro factors were responsible for last week's large bear-steepening of the Treasury curve and which weren't. Strong U.S. economic data - the non-manufacturing ISM survey hit its highest level since 1997 (Chart 2) - and Fed Chairman Powell commenting that the fed funds rate is "a long way from neutral at this point, probably" were the key drivers of the move.1 Taken together, these two developments suggest that the Fed is further behind the curve than was previously thought. This is consistent with an upward revision to the market's assessment of the neutral fed funds rate, which explains why the yield curve steepened and the price of gold edged higher.2 But it's equally important to note the factors that didn't drive the increase in yields. In this case, yields weren't driven by a rebound in growth outside of the U.S., which continues to flag (Chart 2, panel 2). The Global Manufacturing PMI fell for the fifth consecutive month in September. While our diffusion index based on the number of countries with PMIs above versus below the 50 boom/bust line ticked higher (Chart 2, panel 3), our diffusion index based on the number of countries with rising versus falling PMIs remained deeply negative (Chart 2, bottom panel). Chart 2Growth Divergences Deepen Chart 3Global PMIs Taken together, our diffusion indexes are consistent with an environment where most countries are experiencing decelerating growth from high levels. This message is confirmed by looking at the PMIs from the five largest economic blocs (Chart 3). The Eurozone PMI continues to fall rapidly, though it remains well above 50. The Emerging Markets (ex. China) PMI is also trending lower from a relatively high level, while the Chinese PMI is threatening to break below 50. Only the U.S. and Japan have healthy looking PMIs. The precariousness of non-U.S. growth leads us to reiterate the biggest risk to our below-benchmark duration view. The risk is that weak foreign growth eventually migrates to the U.S. via a stronger dollar and forces the Fed to pause its +25 bps per quarter rate hike cycle. If current trends continue, it is highly likely that U.S. growth will slow in the first half of next year, though it is unclear whether such a slowdown would be severe enough for the Fed to pause rate hikes.3 In any event, the bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (3 more hikes) before going on hold (Chart 4). Essentially, the market already discounts a rate hike pause, even after last week's large increase in yields. Chart 4Market's Rate Expectations Still Too Low For this reason, we prefer to maintain our below-benchmark portfolio duration stance, and to hedge the risk of weakening foreign growth by owning curve steepeners,4 and maintaining only a neutral allocation to spread product. Bottom Line: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. In Case You Needed Another Reason To Be Nervous About Junk As Treasury yields broke higher last week, the average high-yield index option-adjusted spread tightened to a fresh cyclical low of 303 bps. It has since rebounded to 316 bps (Chart 5). Our measure of the excess spread available in the high-yield index after adjusting for expected default losses is now at 196 bps, well below its historical average of 247 bps (Chart 5, panel 2). We have previously pointed out that even this below-average excess spread embeds a very low 12-month default loss expectation of 1.07%.5 Rarely have default losses been below that level. With job cut announcements forming a tentative bottom (Chart 5, bottom panel), we see high odds that default losses surprise to the upside during the next 12 months. In the absence of further spread tightening, that would translate to 12-month excess junk returns of 196 bps or less. But this week we want to highlight an additional risk to junk spreads. That risk being our Commodity & Energy Strategy service's view that crude oil prices could experience a positive supply shock in the first quarter of next year. At present, our strategists see high odds of $100 per barrel Brent crude oil in the first quarter of next year, and are forecasting an average price of $95 per barrel for 2019. At publication time, the Brent crude oil price was $85.6 At first blush it isn't obvious why high oil prices would pose a risk to junk spreads, and in fact 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 (Chart 6). Chart 5Default Loss Expectations Too Low Chart 6Higher Oil Vol = Wider Junk Spreads Would higher oil prices necessarily induce a spike in implied volatility? Not necessarily. It turns out that what matters for implied oil volatility is the slope of the futures curve.7 A contangoed futures curve where long-dated futures trade at a higher price than short-dated futures tends to be associated with high implied volatility. A steeply backwardated futures curve where long-dated futures trade well below short-dated futures is equally associated with elevated implied vol (Chart 7). Implied volatility tends to be lowest when the futures curve is in mild backwardation. A mild backwardation is typical when crude prices are in a gradual uptrend, as is the case at present. All in all, the following features provide a reasonable description of the current environment: Gradual uptrend in crude oil price Mild oil futures curve backwardation Low implied crude volatility Tight junk spreads However, as we head into next year, our commodity strategists anticipate that supply constraints will bite in the oil market. The U.S. is poised to implement an oil embargo against Iran in November, and Venezuela - another important oil exporter - remains on the brink of collapse. With global oil inventories already tight, and the loss of further production from Venezuela and Iran looming, our strategists anticipate that the number of days of demand covered by crude oil inventories will decline sharply. This decline will lead to a steep backwardation of the futures curve (Chart 8). Chart 7Brent Crude Oil Volatility Vs. Forward Slope Chart 8Supply Shock Will Lead To Steep Backwardation 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. We continue to recommend only a neutral allocation to high-yield in U.S. bond portfolios. We will await a signal that profit growth is set to deteriorate before advocating for a further reduction in exposure. Still No Buying Opportunity In EM Sovereigns Chart 9EM Index Spread Looks Cheap As growth divergences between the U.S. and the rest of the world increase, we are on high alert for an opportunity to shift some allocation out of U.S. corporate credit and into USD-denominated emerging market (EM) sovereign debt. However, so far EM spreads are simply not wide enough to merit attention from U.S. bond investors. This is not apparent from the average index spreads. In fact, a quick glance at the indexes shows that EM sovereign spreads have widened a lot relative to duration- and quality-matched U.S. corporates, and actually offer a healthy spread pick-up (Chart 9). However, a more detailed look at the spreads from individual countries shows that the spread advantage in EM is only available in a select few markets (Charts 10A & 10B). At the lower-end of the credit spectrum: Turkey, Argentina, Ukraine and Lebanon all offer higher breakeven spreads than comparable U.S. corporates. In the upper credit tiers: Saudi Arabia, Qatar and United Arab Emirates (UAE) look attractive. All other EM countries off lower breakeven spreads than comparable U.S. corporates. Chart 10ABreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Chart 10BBreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates We would be very reluctant to shift any allocation out of U.S. corporates and into either Turkey or Argentina. Both of those countries are highly exposed to the tightening in global liquidity conditions that occurs alongside a strengthening U.S. dollar. Our Foreign Exchange and Global Investment Strategy teams created a Vulnerability Heat Map to identify which EM countries are likely to struggle as the U.S. dollar appreciates (Chart 11).8 These tend to be countries with large current account deficits and high external debt balances, though several other factors are also considered. The results show that Argentina and Turkey are the two most exposed nations. Chart 11Vulnerability Heat Map For Key EM Markets At the upper-end of the credit spectrum, the USD bonds from Saudi Arabia, Qatar and UAE are more interesting. Our geopolitical strategists anticipate an escalation of tensions between the U.S. and Iran following the U.S. midterm elections, and such tensions could increase the political risk premium embedded in all Middle Eastern debt. But for longer-term U.S. fixed income investors, it is worth noting that extra spread is available in the hard currency sovereign debt of Saudi Arabia, Qatar and UAE compared to A-rated U.S. corporates. Bottom Line: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Powell's full interview can be viewed here: https://www.youtube.com/watch?v=-CqaBSSl6ok 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com, where we note that every time the Global (ex. US) LEI has dipped below zero since 1993, the U.S. LEI has eventually followed. 4 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, "Calm Before The Storm In Oil Markets", dated August 2, 2018, available at ces.bcaresearch.com 8 Please see Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights U.S. data keep surging, ... : The September ISM surveys, and the latest employment situation report, demonstrated that the economy has considerable momentum. ... and the Fed has taken note, ... : Chairman Powell and other FOMC speakers reiterated that they see no reason to de-escalate their tightening campaign. ... so we still see rates going higher, ... : Conditions do not justify checking any of the boxes on our checklist of items that might lead us to change our below-benchmark duration view. Only the international-duress box has moved closer to being checked, but nothing short of dire EM conditions will deter the Fed from following its intended path. ... and expect that concerns about the yield curve will abate for a while: The strong data and Powell's comment potentially implying a higher terminal rate promoted a bear steepening all along the yield curve. Feature It is a testament to how smoothly U.S. equities have been rising that Thursday's and Friday's 1% intraday S&P 500 declines inspired CNBC to frame the screen in fire-engine red, accompanied by a Market Sell-Off graphic. We all have to make a living, though, and it's easy to sympathize with a desperate producer. Episode after episode of Goldilocks is hardly must-see TV. Friday's employment situation report provided no relief. September payroll additions fell well short of the consensus estimate, but upward revisions for July and August more than offset the headline disappointment. The three-month moving average of 190,000 net additions is squarely within the tight range that has prevailed for several years. Forward guidance has been leached of any sort of drama as everyone on the Fed is singing from the same sheet - the economy's great; risks are balanced; and we're doing a fantastic job, if we do say so ourselves - and pointing to a continuation of the gradual pace. The market story will become more lively when inflation comes on much more strongly than either markets or the Fed seem to imagine it could, but that is next year's business (at the earliest), and we remain constructive in the meantime. More Strong Data (Yawn) The narrative that fiscal stimulus will keep the economy humming throughout this year and next is old news. Additionally, fiscal stimulus delivers the most bang for the buck when an economy is operating below potential; now that the output gap is closed, the odds are tilted against material positive surprises. Against that backdrop, last week's non-manufacturing ISM survey was startlingly robust. According to the Institute for Supply Management, the 61.6 reading, just off of the series' all-time high, corresponds to 4.6% real GDP growth. The components of the survey were strong across the board (Chart 1), with employment activity making a new all-time high (Chart 1, second panel). The prices-paid and supplier-delivery series, which provide insight into margin pressures, are contrary indicators once they get too strong, but each has yet to break out (Chart 1, bottom two panels). The September manufacturing ISM survey cooled a bit from August, but remains around 60, in the neighborhood of last cycle's high. Taken together, the two ISM surveys indicate that businesses are feeling flush, despite the deceleration in the rest of the developed world (Chart 2). Chart 1Firing On All Cylinders Chart 2American Exceptionalism The September employment report suggests that households should remain optimistic as well. Payroll growth has churned steadily ahead for seven years, and our payrolls model is calling for a pronounced uptick through the first quarter of 2019 (Chart 3). Expressed as a share of the labor force, initial claims continue to melt (Chart 4, top panel), and even after incorporating continuing claims, it looks like there's a job for everyone who wants one (Chart 4, bottom panel). A pessimist would say there's only one way that initial claims can go from here, but as the gaps between the circles and the shading show, there's typically a decent lag between the trough in claims and the onset of a recession. Chart 3The Employment Outlook Is Strong ... Chart 4... Given Initial Claims' Ongoing Collapse The bottom line is that U.S. demand is poised to remain strong. Data from the ISM and NFIB surveys, and the consumer confidence series, indicate that businesses and households are both feeling their oats. Payrolls should keep expanding, and the tight-as-a-drum labor market will keep wages nosing higher. With an elevated savings rate providing ample dry powder for additional consumption (Chart 5), the expansion should sail right through 2019. Chart 5Plenty Of Dry Powder For Consumption "A Long Way From Neutral" Fed officials have kept up an especially busy schedule of appearances since the latest FOMC meeting two weeks ago. Despite the potential for cacophony, the speakers have been singing the same tune. All agree that the economy is strong, and that the Fed has been meeting its dual mandate with unusual aplomb. The victory laps are off-putting socially, but their economic import could be far greater than their social import if they signal some institutional complacency about inflation. Potential future challenges aside, the FOMC is clearly united in its near-term course. Dovish Chicago President Evans, who has publicly agonized in recent years about the dangers of too-low inflation while pleading with his colleagues not to move too fast, has made his peace with the committee's gradual rate-hike pace. In a speech last Wednesday, he stated that, "I am more comfortable with the inflation outlook today than I have been for the past several years." In a subsequent interview with Bloomberg, he said, "Getting policy up to a slightly restrictive setting - 3, 3¼% - would be consistent with the strong economy and good inflation that we are looking at. ... I'm quite comfortable with the expected path." The week before, New York Fed President Williams was effusive in his praise of the economy's health and the Fed's role in sustaining it. "[T]he U.S. economy is doing very well overall. From the perspective of the Fed's dual mandate ..., quite honestly, this is about as good as it gets. ... The Fed has attained its dual-mandate objectives of maximum employment and price stability about as well as it ever has." Williams' speech may have been most interesting in its downplaying of the usefulness of the neutral-rate concept. The co-developer of the preeminent Laubach-Williams neutral-interest-rate model, Williams now says the idea is overblown, having "gotten too much attention in commentary about Fed policy. Back when interest rates were well below neutral, r-star [the estimate of the neutral rate] 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. More than that, r-star is just one factor affecting our decisions[.]" Williams' pivot would seem to suit Chairman Powell, who has shown little enthusiasm for neutral-rate models. His speech Tuesday on the Phillips curve relationship between inflation and unemployment was mostly anodyne, though he did repeatedly stress the importance of keeping inflation expectations anchored. His interview at a public forum on Wednesday was more revealing. While he continually expressed the view that he thinks the risks to the economy are balanced, he had much more to say about not hiking enough than he did about hiking too much. Now we've come to a situation where unemployment is close to a 20-year low and headed lower, by all accounts, and the really extraordinarily accommodative, low interest rates we needed when the economy was quite weak, we don't need those any more, they're not appropriate any more. We need interest rates to be gradually, very gradually, moving back toward normal, and that's what we've been doing now, for basically three years, and interest rates have just now, in real terms, moved above zero. Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral. Not that they'll be restraining the economy - we may go past neutral, but we're a long way from neutral at this point, probably.1 Our Rates Checklist Treasuries sold off sharply on Wednesday on the non-manufacturing ISM release and reports of Powell's "long way from neutral" remark. The sell-off was in line with the key pillar of our bearish duration view: the Fed will hike more than markets currently expect. Higher bond yields last week suggest the divergence between our view and the markets' view is converging in our favor. Despite the backup in yields, though, market expectations of the terminal rate are still below 3%, indicating that market participants don't expect the 25-bps-a-quarter pace to continue beyond next June. The market still has a ways to go to catch up to our 3.5-4% terminal rate forecast (Chart 6), so we are not yet close to checking the first box of the checklist (Table 1). Chart 6Fighting The Fed Table 1Rates View Checklist From the inflation section of the checklist, inflation break-evens have drifted higher. They are moving in line with our rates view, but not so swiftly that it no longer applies (Chart 7). All of the labor market indicators support the view that rates are going higher. The unemployment rate remains on course to decline, ancillary indicators of the labor market remain quite healthy, and average hourly earnings kept the beat in the September employment release (Chart 8). Chart 7Bonds Have Yet To Adjust ... Chart 8... To Building Inflation Pressures Duress in selected EM economies is the only item that has moved against our rates view since we rolled out the rates checklist last month. It is nowhere near acute enough to show up in the United States, however, so we are still a long way from checking the box. The bottom line is that strength in the U.S. economy should support higher real rates and push up inflation pressures, while the market has yet to revise its terminal-rate estimates upward. The combination supports higher rates three to twelve months down the road, even if lopsided below-benchmark positioning argues for near-term retracement. Investment Implications Expansions do not die of old age, they die because the Fed murders them. While we agree with many bond bulls that the Fed will eventually tighten monetary conditions enough to induce a recession, we do not think it will do so any time soon. BCA's modeled estimate of the equilibrium fed funds rate has been creeping higher, in line with a terminal rate somewhere between 3.5 and 4%. Given the median FOMC member terminal-rate projection of 3 3/8%, and Chicago President Evans' view that the terminal rate is somewhere around 3%, the Fed's not prepared to choke off the expansion just yet. Only rising inflation, and/or rising inflation expectations, will push the Fed to tighten policy enough to really squeeze the economy. We expect that inflation pressures will begin to show themselves over the next twelve to eighteen months as capacity bottlenecks emerge, and the Phillips curve relationship finally asserts itself. Treasuries will be an overweight once the Fed intervenes forcefully to counteract those inflation pressures, but they will be an underweight for a while first. In other words, we think long yields have to rise before they can fall. In line with the BCA house view, we remain equal weight equities, underweight fixed income, and overweight cash. We remain somewhat more constructive than our colleagues on risk assets, however, so we tweak the equity recommendation to say that investors should maintain at least an equal-weight position. Bull markets tend to sprint to the finish line, and underweighting equities too soon could prove hazardous to a manager's relative performance. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 October 3rd interview with Judy Woodruff at The Atlantic Festival. https://www.youtube.com/watch?v=lEPcPIYTMY0 Quoted passage runs from 7:26 to 8:06.

Underweight In our previous Insight, we highlighted the S&P REITs index’s tight inverse correlation with UST yields, but it is far from the only group with this trait. The S&P telecom services index (now a subsector within the S&P communication services index, please see our recent Special Report1), with its predictable earnings stream and dividend payout, trades on the same basis. The spike in yields is thus a negative omen for telco stock prices. It is worth noting that the S&P telecom services index has been bucking its inverse correlation with UST yields since hitting their nadir in mid-2017 (second panel). We expect the beaten-up sector to reestablish the correlation, particularly since telecom’s share of the consumer’s wallet is at a decade low with momentum to continue lower. Bottom Line: Stay underweight the telecom services index. The ticker symbols for the stocks in this index are: BLBG: S5TELSX - T, VZ, CTL.   1 Please see BCA U.S. Equity Strategy Special Report, “New Lines Of Communication” dated October 1, 2018, available at uses.bcaresearch.com.

Underweight The spike in UST yields have been weighing on fixed income-proxy sectors with REITs foremost among them. As noted in the top panel of the chart, excluding the inflating of the property bubble in advance of the GFC, REITs have had a very tight inverse correlation with UST yields; the resulting downward pressure on the S&P REITs index is thus very predictable. Such downward pressure could be overlooked if all was well on an operating basis but this is not the case. Non-residential construction continues to rise (albeit more slowly than last year) in the face of higher borrowing rates (second panel). Further, demand looks slack as occupancy rates clearly crested at the beginning of last year (bottom panel). As well, on the residential front, multi-family housing starts remain elevated which should prove deflationary to rents. Bottom Line: We reiterate our underweight recommendation on the S&P REITs index. The ticker symbols for the stocks in this index are BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE.

We have long argued that the U.S. economy can withstand a tightening of up to 100-125bps (using the 10-year UST yield) in a short time span. Empirical evidence supports our view, and with regard to stocks, what is most important is the correlation between the bond yield year-over-year change and momentum in the SPX (middle panel). In early March, we compared cyclical momentum in the S&P 500 with the annual change in the 10-year UST yield and documented the correlation shifts going back to the 1960s. We also filtered for a minimum of 100bps change in the 10-year UST yield and a concurrent negative correlation between the two variables. In other words, we searched for tightness in monetary conditions that caused equity market consternation, excluding recessions. Our analysis revealed that there have been five iterations when rising bond yields proved restrictive for equities: once in each of the 1960s, 1970s and 1990s and twice in the 1980s. On average, the SPX drawdown from peak-to-trough during these five iterations was 19% and lasted 6.5 months. While the correlation currently has clearly made a turn toward the zero line (bottom panel), it is not in negative territory yet. Using this simple rule of thumb suggests that it would take a selloff in the bond market that pushed yields above 3.70% to cause a significant hiccup in stocks (as a reminder this year’s trough in the 10-year UST yield is 2.72%). With regard to portfolio positioning and given BCA’s interest rate view of a continuation of a selloff in the bond market, we would shy away from interest rate-sensitive sectors (please see the next Insights).