Economy

Special Report

Highlights The presidential race between Haddad and Bolsorano will be very tight. At present, we put slightly higher odds on Haddad winning by a small margin in the second round. A Haddad victory would lead to a continuation of stress in financial markets. The prospects of Lula's release and populist policies will lead to further downside in Brazilian assets Bolsorano's victory in the second round will likely lead to a tradeable rally in Brazil's financial markets. For now continue underweighting Brazilian equities and credit and continue shorting the BRL. We will consider whether to upgrade Brazil after the outcome of the elections becomes clearer. Feature Chart 1Potential Roadmaps For Equities Relative Performance Brazil's upcoming general elections will be among the closest in recent history. Current polls show a tight race between right-wing candidate Jair Bolsonaro and left-wing candidate Fernando Haddad. A victory by Bolsonaro may spark a short-term rally in Brazilian assets on the expectation of structural reforms. On the other hand, a Haddad victory and return of the Worker's Party to power would be quite negative for financial markets. The upside of this election, regardless of outcome, is that a new government with a new mandate will be formed, restoring a semblance of legitimacy for the first time since the impeachment of President Dilma Rousseff in 2016. The downside is that this mandate will be weak, the odds of a "pro-market" government are uncertain, and Congress will be fragmented. Much-needed yet painful social security reforms will face an uphill battle, with potentially another market riot needed to motivate policymakers and legislators to enact social security reforms. On the macroeconomic front, Brazil does not have a lot of room and time for maneuver. Without drastic measures to cut the budget deficit or boost nominal GDP, public debt will most likely spiral out of control. Due to the current state of polarization, we cannot have a high conviction view on the election outcome until after the congressional elections on October 7. That said, the macro forces remain negative for EM overall and Brazil in particular. Barring Bolsorano's victory in the second round, there is little reason for Brazilian risk assets to rally (Chart 1). An Anti-Establishment Victory? Media attention has centered on Bolsonaro of the Social Liberal Party. He is the frontrunner in the first round of the race, despite his controversial rhetoric and overt sympathies with Brazil's military dictatorship of the past. In polling for the second round, his considerable lead has shrunk, as he is now neck and neck with the other contenders (Chart 2). Bolsonaro is a serious candidate not because of any overarching, international "Trumpian" narrative, but because Brazil itself is ripe for an anti-establishment electoral outcome: With Lula out of the race, the combined "right-wing" and "left-wing" vote is close in the first round (Chart 3). Chart 2Second-Round Polls Very Tight Chart 3A Tight Race The country is still in the throes of a political crisis and a historic recession (Chart 4). The major political parties have been discredited. Years of slow economic growth have resulted in extremely low levels of public trust in government (Chart 5). Chart 4Brazil In The Wake Of A Historic Recession Chart 5Low Growth Countries Suffer From Lack Of Trust In Their Government This is prompting voters to seek a "change in direction" and/or a "protest vote," from which Bolsonaro is apparently benefiting. There is even a sizable audience for Bolsonaro's authoritarianism and nostalgia for military rule. Brazilians are disillusioned with democracy - with 67% of respondents in a Pew Research poll saying they are "not satisfied" with democracy, compared to a global median of 52%.1 Almost a third of educated Brazilians favor military rule, and that number is as high as 45% among the uneducated (Chart 6).2 Bolsonaro's net approval is less negative than other candidates. In fact, only former Presidents Lula and Rousseff have higher net approval (Chart 7). This is a serious risk to Bolsonaro's likeliest rivals, Fernando Haddad of the Worker's Party and Ciro Gomes of the Democratic Labor Party. Bolsonaro's stabbing at a rally on September 6 has not taken him out of the race. His social media support has become an important tool to reach out to his fan base. Chart 6Brazilian Voters Harbor Some Authoritarian Tendencies Chart 7Net Approvals Advantage Bolsonaro However, there are two key reasons why Bolsonaro is not the favorite to win the election: First, Brazil's two-round electoral system works against Bolsonaro because it enables left-leaning voters to vote strategically in favor of the "least bad option," i.e. the available left-of-center candidate, in the second round. Thus while polling shows Bolsonaro very close to each of his potential opponents in the second round, his final opponent will receive a boost that will not be fully accounted for until after the first round eliminates other left-wing contenders. Recent polls suggest that Haddad stands to benefit much more than Bolsonaro from the "migration" of votes after the first round, as left-wing supporters team up against Bolsonaro in the second round (Table 1). Second, with Lula disqualified from the race, Lula supporters are now in the process of switching to support Haddad. Lula has carried a high approval rating of around 35%-40% for over a year, well above all other candidates. In our "poll of polls" (average of various polls) Haddad has risen rapidly in the one month since Lula's disqualification became clear, so that he is now at equal odds with Bolsonaro (see Chart 2 above). A few polls even suggest Haddad is ahead of Bolsonaro in the second round (Chart 8).3 Table 1Second Round Migration##br## Polls Advantage Haddad Chart 8Haddad Is Ahead##br## In These Polls To elaborate on this last point: First, about 59% of Lula's supporters say they will shift to Haddad (Chart 9), which should be enough to position him as one of the top two contenders in the first round of voting. Only 4% of Lula supporters will shift to right-of-center candidate Alckmin- a share that is overpowered by the 71% of the Lula vote that will go to left-leaning candidates. Second, the number of undecided and "blank" Lula voters is high at 18%. These voters - if they vote - will mostly go to Haddad, and then Gomes. From the above we can conclude that Haddad will face Bolsonaro in the second round runoff. Because of strategic voting, Haddad will be favored to win the Presidency. A major risk to the left-wing candidate in the second round is that as many as 18% of Lula voters may stay home and not vote. This would mean that Haddad could lose the final vote due to low turnout.4 Overall voter turnout has been falling slightly since 2006 (from 83.3% to 80.7% in 2014) and the disillusionment of voters could result in still lower turnout in 2018. This would favor Bolsonaro, whose supporters are the most likely to vote, whereas Haddad's are the least likely, according to surveys. The profile of the most likely voters favors Bolsonaro (Table 2).5 Chart 9Lula's Migration Vote Table 2Voter Profile Of Each Candidate As a consequence, we give Bolsonaro 40%-50% odds of winning the presidency, with the possibility of downgrading his probability to a flat 40% if the rise in Haddad's polling continues at the current pace. Strategic voting imposes a handicap on Bolsonaro, making it hard for him to increase his odds above 50%. The lower net approval for Haddad and Gomes, and the risk that Lula voters will fail to transfer in full force to Haddad, suggests that Bolsonaro has a fair chance of winning the second round. Elections are a Bayesian process and we will update our probabilities as more information comes in. In particular, it is important to see if Haddad exceeds expectations in the October 7 first round. Bottom Line: Given strategic voting in the second round and the momentum behind Haddad, the odds of a left-wing victory in the Brazilian election are 50%-60%. However, this is a low-conviction view. Bolsonaro's odds of winning are closer to 40%-50%, particularly if Lula voters stay home. The New Government's Mandate Will Be Weak No matter who wins, there will be at least one positive takeaway for Brazilian risk assets: a new government will be elected with a fresh mandate to lead the country. The Brazilian state has suffered from a crisis of legitimacy over the past few years. A countrywide anti-corruption campaign and economic depression has led to a general loss of confidence. The latter was further exacerbated by the impeachment of President Rousseff and paralysis of the interim government of Michel Temer. Hence this election will clear the air and give a new government the chance to tackle the country's economic and political problems. However, this clearly positive factor will be overwhelmed by negative factors as the election unfolds and in the aftermath: No first round winner: As outlined above, none of the candidates are likely to win a simple majority of the vote in the first round on October 7. This has been the norm in recent elections, but it precludes the possibility that the current crisis will be matched by a leader with a strong personal mandate, like Cardoso in the 1990s. A close election may lead to contested results: The current second-round polling suggests the outcome will be close. The losing side may challenge the results, a controversy that could cause significant political uncertainty for weeks or months. Bolsonaro has already suggested that he can only lose if the Worker's Party rigs the election. Congress will be fractured: Brazil's Congress is always fractious; with numerous parties and coalitions cobbled together by presidents whose own party has a relatively small share of seats (Chart 10). The upcoming president may even have a weaker congressional base than usual. The erstwhile dominant parties, the PDMB and the PSDB, are less popular than they once were and have put forward lackluster presidential candidates, suggesting they will not win large numbers of seats. The Worker's Party, with a large support base in recent decades, was at the epicenter of the impeachment crisis and suffered huge losses in the municipal elections of 2016, also suggesting it will not win as many seats.6 Meanwhile Bolsonaro's Social Liberal Party is starting from a low base (it currently has only eight out of 513 seats in the lower house and none in the senate). Hence, no party is in a position to sweep Congress, or even come close to a majority, ensuring high diffusion of power, horse-trading, and unstable, ad hoc coalitions. Such coalitions have been a hallmark of Brazilian politics and may even be more unstable this time around. Chart 10ABrazil's Parliament Is Fractious Chart 10BBrazil's Parliament Is Fractious No more pork: Given the focus on fiscal austerity and corruption, the next president of Brazil will struggle to command as much "pork-barrel spending" - politically-motivated fiscal handouts to individual congress members - to grease the wheels of politics. President Lula and President Cardoso both relied on pork to ensure passage of key legislation in the 1990s and early 2000s. Polarization: Polarization will remain high as a result of the economic crisis. If Haddad wins, we expect that he will pardon President Lula, despite his assertions to the contrary, and create ill-will among the roughly 52% of the population that views Lula as corrupt. If Bolsonaro manages a victory, he will face intense opposition and resistance from civil society and possibly a left-of-center Congress. Historically, a governing coalition with a majority of seats eventually emerges from Brazil's fragmented Congress. However, periods of political crisis - and transitions from one leading party to the next - often require more time to form such coalitions. It took Lula two years, from 2002-04, to form a majority coalition during his first term in office, according to research by Taeko Hiroi of the University of Texas at El Paso (Chart 11). Chart 11Historical Profile Of Governing Coalitions Bottom Line: The formation of a new government with a new mandate is positive but it will not bestow as much political capital as the market expects: in all likelihood the new president's mandate will be weak and Congress will, at least initially, be divided. Will Reforms Be Reactive Or Proactive? What are the likely market reactions from the different election scenarios? And will policymakers be proactive or reactive in their pursuit of any structural reforms? While we cannot rule out a knee-jerk rally if Bolsonaro wins, the length and breadth of the market reaction will depend on the government's political capital (e.g. popular margin of victory and strength in Congress) and willingness to be proactive about structural reforms. On the left, both Haddad and Gomes are "populist," left-leaning, candidates whose victory would exacerbate the selloff. Haddad's vice-presidential candidate and coalition partner is Manuela D'Avila, from the Brazilian Communist Party (PCdoB). Their platform states that the solution to low economic growth is expansionary fiscal and monetary policies, such as a removal of the cap on government spending and a reduction in interest rates. Meanwhile the Gomes campaign has denied that Brazil has a pension deficit.7 Neither Haddad nor Gomes faces the IMF-imposed constraints that Lula faced when he took power in 2002. The market pressure surrounding his election in 2002 and the IMF proposals at that time essentially forced Lula to continue his predecessor Cardoso's reforms. Compared to 2002-03, today's profile of Brazilian share prices suggests that more downside is warranted (see Chart 1, page 1). Hence, we believe more market turmoil would be necessary to force Haddad or Gomes to adopt any difficult and unpopular fiscal reforms. We believe that both could be capable of executing reforms if pressed by the market, but a market riot is needed first. On the other hand, a Bolsonaro victory would likely trigger a meaningful rally on the expectation of pro-market reforms. Bolsonaro's economic advisor Paulo Guedes, a University of Chicago economics PhD holder, is a supply-side reformer who has proposed to privatize state-owned assets, enact tax and pension reforms, and scale back the bureaucracy. Crucially, Bolsonaro's camp wants to use the proceeds from privatization to repurchase public debt and buy time before reforming the pension system. Hence, in the eyes of many investors, Bolsonaro represents a market-friendly candidate despite his tough talk and anti-establishment tendencies. The problem is that Guedes has spent far more time giving interviews to the financial press than campaigning on draconian structural reforms. As such, it is not clear that Bolsonaro's economic team's promises jive with the desires of the median voter in the country. Bolsonaro, meanwhile, will likely be limited in forming a coalition in the Chamber of Deputies.8 The ability to form and maintain alliances in the Chamber of Deputies is a key constraint for any Brazilian president, especially from a smaller party. Obstructionism is common.9 Even large parties with strong alliances have fallen into gridlock, most obviously in attempting structural reforms. In late 1998, for instance, President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999. In short, it will be difficult for the new president to implement reforms at the beginning of his term even though, as noted above, Brazilian presidents tend to cobble together a coalition over time. It should be noted that Bolsonaro's authoritarian tendencies and desire to rewrite the 1988 constitution - a partisan Pandora's Box - could result in a further deterioration of Brazilian governance (Chart 12). This would push up the risk premium on assets over the long run, though in the short run Bolsonaro may be positively received by financial markets. Bottom Line: Bolsonaro would likely want to be a proactive structural reformer, but he would also be constrained at first due to his small party base in Congress and need to form a coalition. In addition, the days of liberally soothing partisan battles with pork-barrel spending are over. Brazil is both fiscally constrained and increasingly sensitive to corruption. Moreover, fiscal austerity would come with a negative hit to growth in the short term. It is not clear whether Bolsonaro will be able to form a Congressional coalition that can push through the painful part of the "J-Curve" of structural reform (Diagram 1). Chart 12Brazilian Governance Set To Fall Further Diagram 1The J-Curve Of Structural Reform On the other hand, neither Haddad's nor Gomes's platforms are market-friendly. Neither is likely to attempt structural reforms proactively. The market would have to sell off further, as in 2002, to pressure them into such policies. At that point, however, they might ultimately have a better ability to push legislation through Congress than Bolsonaro due to their ability to form larger coalitions amongst leftist parties. Either way Brazilian risk assets have further downside from where they stand today. A market riot is likely necessary to galvanize the population's support for painful structural reforms. That support currently does not exist. What Is At Stake? Chart 13The Achilles Heel Of The Brazilian Economy Brazil's public debt is out of control. Weak nominal GDP growth and high borrowing costs are increasing the public debt burden. This debt stems in large part from a sizable social security deficit that will continue expanding without the above-mentioned reforms (Chart 13). Thus, the next president will face a dilemma: implement austerity to satisfy creditors or increase spending to satisfy voters. A close look at voter preferences suggests that top priorities are improving health services and raising the minimum wage, while pension reform is at the bottom of the list (Chart 14). This reinforces our view that the left-of-center candidates are likely to be the closest to the median voter, and that fiscal austerity is not forthcoming. However, voters are also demanding that inflation be controlled, taxes be cut, and jobs be created - all of which could result in support for right-of-center candidates. Two possibilities to stabilize or reduce the debt load are: (1) restoring a primary budget surplus by enacting social security cuts and/or (2) privatizing state assets to raise fiscal revenues. In Europe throughout the early 2000s, peripheral countries with large public debt imbalances ran large primary budget deficits, just as Brazil has been running (Chart 15, top panel). Portugal, Ireland, Italy, Greece, and Spain stabilized their debt-to-GDP ratios by cutting social spending and capping fiscal expenditures (Chart 15, bottom panel). This will prove challenging as Brazil's pension system is one of the most generous in the world, with retirement ages of 54 and 52 for men and women, respectively, and a much lower contribution period relative to other countries. Furthermore, replacement rates for both men and women are 61%, or 10 percentage points above the OECD average and over 15 percentage points above other countries' reformed pension systems.10 Finally, the dependency ratio will continue to increase, as rising life expectancy and a declining working-age population remain structural headwinds for years to come.11 In our conversations with clients, the reality of Brazil's aging demographics usually comes as a complete surprise. Chart 14Brazil's Population Is ##br##Not Open To Fiscal Austerity Chart 15Eurozone Debt Crisis Resulted ##br##In Lower Spending And Stable Debt Therefore, social security reforms require outright cuts in spending, rather than soft caps on the budget balance. The present soft cap on government expenditures is not adequate to stabilize or reduce government debt levels. Could privatization help stabilize public debt dynamics? The privatization program during the 1990s under the Collor, Franco, and Cardoso governments led to the sale of $91 billion (around R$ 100 billion or 9% of GDP) worth of assets from 107 state-owned enterprises over the course of a decade. Presently, in order to re-balance the primary deficits of R$93 and R$79 billion for 2018 and 2019 respectively, the government would be required to frontload the sale of large state-owned entities, such as Petrobras or Banco do Brasil. This will prove challenging, since the sale of state-owned enterprises requires legislative approval. In fact, over the past two years, under interim President Temer, the government has struggled to sell its assets such as Electrobras. Even assuming that a Brazilian government under Bolsonaro conducts large-scale asset sales, previous privatization programs have failed to yield targeted sums and have required a longer time to implement than originally expected. Overall, privatization is not a feasible option to reduce high debt levels in Brazil in the short run. Bottom Line: Stabilizing or reducing the public debt as a share of GDP will be challenging under the current set of preferences set by voters. Moreover, demographic headwinds and structural constraints embodied in Brazil's two-tier legislative system will slow down the process of privatization and pension reform. The market is forward-looking and will cheer attempts to enact supply-side reforms in the short run, should they emerge, despite long-term uncertainties. The key questions are (1) whether the election produces a proactive Bolsonaro regime or a reactive left-wing regime (2) whether coalition formation - in Bolsonaro's case - or exogenous market pressure - in Haddad's case - are sufficient to initiate reforms in a timely manner in 2019. Amidst a broad EM selloff driven by external factors as well as Brazil's and other EM's internal fundamentals, we expect the markets to be largely disappointed in 2019. The evolution of the political context throughout the year will then determine when and if a buying opportunity emerges. Investment Implications In the late 1990s, faced with high foreign debt levels, a large current account deficit, and weak nominal growth, the Brazilian central bank devalued the real by 66% in January 1999 (Chart 16). This led to a rebound in nominal growth which helped the country relieve itself from built up excesses. In today's context, a weaker currency and lower interest rates are required to boost nominal GDP and contain Brazil's public debt as a share of GDP. There are already signs that the central bank is easing liquidity amid currency depreciation - which stands in contrast of the recent past (Chart 17). More liquidity provisioning by the central bank will cause the real to depreciate further. In light of this, we recommend that investors continue shorting the currency versus the U.S. dollar. Furthermore, due to our expectation of further deceleration in global growth stemming from China and a strong dollar, investors should expect more downside in broader EM and Brazilian share prices in U.S. dollar terms. With respect to the outcome of the elections, investors should continue underweighting Brazilian equities and credit in their respective portfolios for now (Chart 18). Chart 16Brazil Needs A Weaker Currency To##br## Boost Nominal Growth Chart 17A New##br## Paradigm Shift? Chart 18Sovereign Credit Spreads Will##br## Continue Widening We will consider whether an upgrade of Brazil is warranted after electoral outcomes become known. Particularly, the balance of the parties in Congress and the new president's coalition formation options will dictate the relative performance of Brazilian equities and credit over the next 6-12 months. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see, Wike, R. et al., "Globally, Broad Support for Representative and Direct Democracy", October 16th, 2017, available at http://www.pewglobal.org/2017/10/16/many-unhappy-with-current-political-system/ 2 In addition to the Pew Research data cited in Chart 5, please see Dora Saclarides, "Do Brazilians Believe In Democracy?" InoVozes, The Wilson Center, November 21, 2017, available at www.wilsoncenter.org. 3 Please see "Brazil: Vox Populi Poll Gives Haddad Lead In Presidential Race," Telesur, September 13, 2018, available at www.telesurtv.net, & Data Poder 360 poll from September 21st, available at: https://www.poder360.com.br/datapoder360/datapoder360-bolsonaro-tem-26-e-haddad-22-os-2-empatam-no-2o-turno/ 4 Please see, BTG Pactual September 15-16 poll, page 18. The Polls states that 57% of Lula voters would "not vote at all" while 41% would vote for Haddad. While turnout will improve for the second round, this is a risk to Haddad. 5 A poll by Empiricus Research and Parana Pesquisas p56 shows that 89.5% intend to vote (which is unrealistic), and that 95.7% of Bolsonaro voters intend to vote while 91.6% of Haddad voters intend to vote. 6 "The PT lost four of the five state capitals it had run, including Sao Paulo, the country's economic powerhouse where the leftist party was born. The PT lost two-thirds of the municipalities it won in 2012, dropping to 10th place from third in the number of mayors controlled by each party." Please see Anthony Broadle, "Brazil parties linked to corruption punished in local elections," Reuters, October 2, 2016, available at www.reuters.com. 7 Gomes has, however, admitted the need for some adjustments to the retirement age and public sector worker privileges, which suggests that he could be brought to pursue structural reforms under the right circumstances. https://todoscomciro.com/en_us/pnd/ciro-gomes-previdencia-social/ 8 Bolsonaro's legislative experience is also surprisingly thin. As a congressional representative for 27 years, he has only passed two laws, after presenting a total of 171 bills and one amendment to the constitution. Only three of these bills presented were of economic nature. It is unclear whether he has what it takes to galvanize the legislature in pursuit of tricky reforms. 9 Please see BCA Geopolitical Strategy Special Report, "Separating The Signal From The Noise," dated September 10, 2014, available at gps.bcaresearch.com. 10 A replacement rate is the percentage of a worker's pre-retirement income that is paid out by a pension program upon retirement. 11 Ratio measuring number of dependent zero to 14 and over the age of 65 to total working age population

Highlights Duration: The housing market is the key channel through which monetary policy impacts the economy. As such, it is unlikely that Treasury yields will peak until housing shows meaningful weakness. While residential investment has decelerated in recent quarters, we expect this weakness will prove temporary and that Treasury yields have further cyclical upside. Maintain below-benchmark portfolio duration. Yield Curve: The Fed will maintain its 25 bps per quarter rate hike pace for the time being, but could be forced to pause next year if weak foreign growth migrates to the U.S. via a stronger dollar. We recommend hedging this risk via a long position in the 7-year bullet versus a short position in the 1/20 barbell. Corporate Health: Strong profit growth - both organic and as a result of corporate tax cuts - has led to a significant improvement in corporate balance sheet health during the past few quarters. This improvement will not persist for much longer. We recommend only a neutral allocation to corporate bonds, both investment grade and junk. Feature This time last week the 10-year Treasury yield was bumping up against 3% and money markets were on the cusp of discounting an extra rate hike between now and the end of 2019. Both resistance levels broke during the past seven days. The 10-year yield is now 3.07% and the January 2020 fed funds futures contract is fully priced for four rate hikes (Chart 1). Chart 1Past Resistance Levels With the 10-year yield back above 3%, many investors are once again speculating about where it will ultimately peak for the cycle. Any answer to this question relies on an assumption about the neutral fed funds rate, the level of interest rates above which monetary policy turns restrictive and acts to slow economic growth and inflation. In past reports we have suggested several measures investors can track to help decide whether interest rates are close to breaking above neutral.1 In this week's report we focus on one particularly important indicator - the housing market. In his essential 2007 paper "Housing Is The Business Cycle", Edward Leamer notes that of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.2 Given that recessions are also typically preceded by tightening monetary policy, it is not a stretch to connect the two. In fact, there is good reason to believe that housing is the main channel through which monetary policy impacts the economy. Since leverage is employed in the acquisition of new homes, interest rates impact the cost of homeownership more directly than other assets. A similar claim could be made about leveraged investment from the corporate sector, but business investment is also beholden to swings in expected future demand. Households can easily postpone the acquisition of a new home if the interest rate environment makes it uneconomical, businesses need to act when the market demands it. But most importantly, Leamer's paper demonstrates that, unlike residential investment, weaker business investment does not consistently provide advance warning of recession. The State Of U.S. Housing Turning to the data, we see that Leamer's claim is validated by the top panel of Chart 2. Residential investment tends to decline in the year preceding a U.S. recession. Housing starts and new home sales display a similar pattern (Chart 2, panels 2 & 3). Chart 2The Housing Market Predicts Recessions What's worrying is that residential investment has barely grown at all during the past year (Chart 2, bottom panel). If this weakness continues it would signal that interest rates are too high for the housing market, and that we are likely very close to the cyclical peak in bond yields. However, we doubt the current weakness will persist. For one, the recent decline in construction activity has been concentrated in the multi-family sector while single-family construction continues to expand at a steady rate (Chart 3). This could simply reflect a shift in demand away from multi-family toward single-family, reversing the trend witnessed between 2010 and 2012. It's possible that some households who were forced into the rental market in the aftermath of the Great Recession now find themselves able to switch back. But even if we focus on the multi-family sector exclusively, there is little reason to believe that construction will see significantly more downside. The rental vacancy rate remains very low, and the National Multi Housing Council's Survey of Apartment Market Conditions suggests that there is no strong upward or downward pressure on the vacancy rate at the moment (Chart 3, bottom 2 panels). The fact that single-family housing starts have not declined casts some doubt on the notion that higher mortgage rates are to blame for the deceleration in residential investment. This is further borne out by the fact that, while higher mortgage rates have certainly increased the cost of homeownership, mortgage payments as a percent of median income are not stretched compared to history (Chart 4). The demand back-drop for housing also remains robust, with household formation in a clear uptrend (Chart 4, panel 2) and homebuilders as optimistic as ever about future sales activity (Chart 4, bottom panel). Chart 3A Temporary Weakness In Residential Investment Chart 4Higher Mortgage Rates Are Not The Culprit We conclude that interest rates are still too low to meaningfully impact the housing market. Residential investment will re-accelerate in the coming quarters and Treasury yields have plenty of room to rise before reaching their cyclical peak. Bottom Line: The housing market is the key channel through which monetary policy impacts the economy. As such, it is unlikely that Treasury yields will peak until housing shows meaningful weakness. While residential investment has decelerated in recent quarters, we expect this weakness will prove temporary and that Treasury yields have further cyclical upside. Maintain below-benchmark portfolio duration. Hedging Weak Foreign Growth With Steepeners The resilience of the U.S. housing market makes it likely that interest rates will continue to rise for quite some time. However, this does not preclude weak foreign growth - and the resultant dollar strength - from forcing the Fed to slow its 25 basis point per quarter rate hike pace at some point during the next 6-12 months. In fact, we have flagged in recent reports that, since 1993, every time the Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed (Chart 5).3 Unless foreign growth suddenly recovers, it is quite likely that dollar strength will drag the U.S. LEI lower in the first half of next year. At that point, the Fed may be forced to pause its rate hike cycle in order to take some shine off the dollar, allowing the recovery to continue. Chart 5Weak Global Growth Could Bring Down The U.S. Drops in the U.S. LEI to below zero almost always coincide with a recommendation for easier monetary policy from our Fed Monitor (Chart 5, bottom panel). Although one notable exception did occur in 2005. An examination of the three components of our Fed Monitor reveals that a falling LEI caused the economic growth component of our monitor to decline in 2005 (Chart 6). However, this was offset by an elevated inflation component and extremely easy financial conditions (Chart 6, bottom 2 panels). Chart 6The Three Components Of Our Fed Monitor As in 2005, inflation pressures are once again elevated and financial conditions remain accommodative. It follows that it could take a significant deterioration in economic growth before the Fed is forced to pause its 25 bps per quarter rate hike cycle, one that is not yet evident in the data. Nevertheless, we cannot ignore the risk that weak foreign growth will infiltrate the U.S. via a stronger dollar, forcing the Fed to pause. With only two 25 basis point rate hikes currently discounted for 2019, some pause is already in the price. This makes us reluctant to advocate shifting away from below-benchmark portfolio duration. We think a better way to hedge the risk of a Fed pause is through yield curve steepeners. Since short-dated yields are more heavily influenced by the expected near-term pace of rate hikes than long-dated yields, any Fed pause will cause the yield curve to steepen. Steepeners are also very attractively priced at the moment, meaning that they should even perform well in a mild curve flattening environment.4 Our preferred method for implementing a curve steepener is to go long a bullet maturity near the middle of the curve and short a duration-matched barbell consisting of the very short and very long ends of the curve.5 With that in mind, we can determine the best yield curve trade to implement by answering the following two questions: Which bullet over barbell combination offers the most attractive value? Which bullet over barbell combination is most likely to outperform in the "Fed pause" scenario we are trying to hedge? In response to the first question, we consider the 2-year, 3-year, 5-year and 7-year bullet maturities all relative to a duration-matched 1/20 barbell. All of those butterfly spreads offer approximately the same yield pick-up (Chart 7). They also all offer approximately the same yield pick-up relative to our fair value models, which are based on regressions of the butterfly spread versus the 1/20 slope of the curve (Chart 8).6 To answer the second question, we try to identify which of the 2-year, 3-year, 5-year or 7-year yields is likely to decline the most in response to the market pricing-in a pause in Fed rate hikes. To do this we look at the historical correlations between different yield curve slopes and our 12-month Fed Funds Discounter - the change in the fed funds rate that is priced into the market for the next 12 months. The correlations are displayed in Chart 9, and they show that monthly changes in the 7/10 slope are almost always negatively correlated with monthly changes in the 12-month discounter. In other words, when the discounter falls, the 7-year yield falls by more than the 10-year yield. Chart 7Different Bullets, Similar Yield Pick-Up I Chart 8Different Bullets, Similar Yield Pick-Up II Chart 9Hedging The "Fed Pause" Scenario Monthly changes in the 5/7 slope are also usually negatively correlated with changes in the discounter, though the correlation has been closer to zero in recent years. This makes it difficult to say with certainty whether the 5-year or 7-year yield would fall by more in response to a decline in the discounter. Chart 9 also shows that changes in both the 2/3 and 3/5 slopes are positively correlated with changes in the 12-month discounter. This means that when the discounter falls, the 3-year yield falls by more than the 2-year yield and the 5-year yield falls by more than the 3-year yield. In general, we can safely conclude that the 5-year and 7-year bullets are better hedges against a Fed pause than the 2-year or 3-year bullets. The 7-year in particular appears to be a safe bet. Given that the differences in valuation between the different options are miniscule, we are inclined to maintain our current yield curve position: long the 7-year bullet and short the 1/20 barbell. This week we also close our recommendation to favor the 5/30 barbell over the 10-year bullet for a small loss of 2 bps. This trade was designed to hedge the risk of Fed overtightening leading to an inverted yield curve. This trade would underperform in the event of a Fed pause, which we now view as the greater risk. Bottom Line: The Fed will maintain its 25 bps per quarter rate hike pace for the time being, but could be forced to pause next year if weak foreign growth migrates to the U.S. via a stronger dollar. We recommend hedging this risk via a long position in the 7-year bullet versus a short position in the 1/20 barbell. Corporate Balance Sheet Reprieve Last week's release of the second quarter U.S. Financial Accounts (formerly Flow of Funds) allows us to update our indicators of nonfinancial corporate balance sheet health. Overall, there has been a significant improvement in our Corporate Health Monitor (CHM) since the end of 2016. It has fallen from deep in "deteriorating health" territory to close to the "improving health" zone (Chart 10). By far, the biggest driver of the CHM's improvement has been the sharp increase in after-tax cash flows (Chart 10, panel 2). This is partly due to the recent corporate tax cuts, but also reflects a significant rebound in pre-tax cash flows (Chart 10, bottom panel). Despite the rebound in profits, we remain cautious on the outlook for corporate balance sheets going forward. First, our bottom-up samples of firms included in the investment grade and high-yield Bloomberg Barclays bond indexes both show that the median firm's net debt-to-EBITDA has improved in recent quarters, but remains elevated compared to history (Chart 11). Chart 10After-Tax Cash Flows Drive CHM Improvement Chart 11Debt Levels Still High Second, we see increasing headwinds to profit growth going forward. The positive impact from tax cuts is set to wane, while the stronger dollar and faster wage growth will both weigh on pre-tax profits during the next year.7 It is important to note that it will not take much deceleration in pre-tax profits for corporate balance sheets to worsen. Our measure of gross leverage - total debt over pre-tax profits - has only managed to flatten-off during the past few quarters, even as profit growth has surged. This means that the rapid gains in profits have only managed to keep pace with the rate of debt growth. Even a small deceleration in profits will cause leverage to rise, and rising leverage tends to occur alongside an increasing default rate (Chart 12). Chart 12Gross Leverage And Corporate Defaults Bottom Line: Strong profit growth - both organic and as a result of corporate tax cuts - has led to a significant improvement in corporate balance sheet health during the past few quarters. This improvement will not persist for much longer. We recommend only a neutral allocation to corporate bonds, both investment grade and junk. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 2http://www.nber.org/papers/w13428 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Playing Catch-Up", dated September 11, 2018, available at usbs.bcaresesarch.com 5 For further details on why we prefer this trade construction, please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 6 We calculate the butterfly spread as: the bullet yield minus the yield of the duration-matched barbell. 7 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification