Financial Markets

Highlights Hyman Minsky famously said that “stability begets instability.” The converse is also true: Instability begets stability. None of the preconditions for a U.S. recession are in place yet. The Fed’s decision to press the pause button on further rate hikes ensures that it will take at least another 18 months for monetary policy to turn restrictive. Global growth should accelerate by mid-2019, as Chinese stimulus kicks in and the headwinds facing Europe dissipate. Investors should overweight global equities and underweight bonds over the next 12 months. The leadership role in the equity space will gradually shift outside the United States. Feature The Long Shadow Of The Financial Crisis   "Stability begets instability” declared Hyman Minsky in his widely cited, seldom-read book.1 By this, Minsky meant that periods of economic tranquility often encourage excessive risk-taking, sowing the seeds of their own demise. We would not quarrel with Minsky’s assessment, but we would point out that the converse is also true: Instability begets stability. Following periods of intense financial stress, lenders become more circumspect about whom they lend to, while borrowers become reluctant to take on debt. The result is economically bittersweet. On the plus side, the newfound caution of lenders and borrowers alike ensures that financial imbalances are slow to build up again. On the negative side, sluggish credit growth restrains spending. The net effect is a recovery that is often slow and uneven, but one which lasts longer than expected. Few Signs Of Major U.S. Economic Imbalances This is the world in which we find ourselves today. It took a decade following the subprime crisis for the U.S. to return to full employment. Much of Europe is not even there yet. Lenders continue to take risks. However, they have been quicker than usual to scale back exposure at the first sign of trouble. For example, as U.S. auto loan defaults began rising in 2015, banks tightened lending standards. As a result, the share of auto loans transitioning into delinquency peaked in Q4 of 2016 and has since drifted down modestly (Chart 1). Chart 1Lenders Are More Circumspect These Days: The Case Of Autos A similar thing happened when corporate credit spreads blew out in 2015 following the crash in oil prices (Chart 2). Banks tightened lending standards starting in late 2015. Once defaults peaked in early 2017, banks started easing standards. Chart 2Banks Were Quick To Tighten Lending Standards In 2015 Tellingly, the distress in corporate debt markets in 2015-16 did not cause the financial system to seize up, as evidenced by the fact that financial stress indices only increased marginally during that period. This suggests that financial imbalances never had a chance to rise to a level that threatened the overall economy. The Preconditions For The Next U.S. Recession Are Not Yet In Place Today, the U.S. private-sector financial balance – the difference between what the private sector earns and spends – stands at a healthy surplus of 2.1% of GDP. Both of the last two recessions began when the private-sector balance was in deficit (Chart 3). Chart 3The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions This raises an intriguing question: If the U.S. private sector is not suffering from any major imbalances, what is going to cause the next recession? That’s a very good question, with no obvious answer! The past two recessions were triggered by the bursting of asset bubbles – first the dotcom bubble and then the housing bubble. Today, U.S. equities are far from cheap, but with the S&P 500 trading at 16.1-times forward earnings, they are hardly in a bubble (Chart 4). The housing market is also on much firmer footing: The homeowner vacancy rate is near all-time lows, while the quality of mortgage lending has been very high (Chart 5). Chart 4While U.S. Stocks Are Not Cheap, They Aren't In A Bubble Chart 5Housing Fundamentals Are Solid Of course, recessions can occur for reasons other than the bursting of asset bubbles. The 1973-74 recession and the recessions of the early 1980s were triggered by a surge in oil prices, requiring the Fed to hike rates aggressively. Luckily, such an oil-induced recession is highly unlikely today. Inflation expectations are better anchored, while oil consumption represents a much smaller share of GDP than it did back then (Chart 6). In addition, the U.S. has become a major oil producer, which implies that the drag to consumers from higher oil prices would be partly offset by increased capital spending in the energy sector. At any rate, the ability of shale producers to respond to higher prices with additional output limits the extent to which prices can rise in the first place. Chart 6An Oil Price Shock Is Unlikely To Cause A Recession Past economic downturns have also been caused by major adjustments in the cyclical parts of the economy. As a share of GDP, cyclical spending is lower today than it has been at the outset of most recessions (Chart 7). The proliferation of just-in-time inventory systems has also reduced the influence that inventory swings have on the economy (Chart 8). Chart 7Cyclical Spending Is Not Extended A severe tightening of fiscal policy can also trigger a recession.2 Fortunately, the end of the government shutdown reduces the risk of such an outcome. Rightly or wrongly, voters blamed President Trump for the recent closure (Chart 9). As we speak, the Trump administration is negotiating with Democrats to avert another shutdown slated to begin on February 15. The key item of contention concerns funding for a border wall with Mexico. Even if a deal falls through, rather than shuttering the government again, Trump will probably pursue funding for the wall by declaring a national emergency. Our geopolitical strategists believe such an action will be challenged by the Democrats, but is likely to be upheld by the Supreme Court. Chart 9''I Am Proud To Shut Down The Government'' Global Growth Should Improve Admittedly, the external environment now has a greater influence on the U.S. economy than in the past. Nevertheless, given that exports are only 12% of GDP, it would take a sizeable external shock to knock the U.S. into recession. We think that such a shock is not in the cards. The trade war is likely to go on hiatus as Trump seeks to take credit for a deal with China. In addition, as we discussed two weeks ago, China will scale back its deleveraging campaign now that credit growth has fallen close to nominal GDP growth (Chart 10).3    Chart 10China: Time To Scale Back Deleveraging Euro area growth should reaccelerate over the coming months thanks to lower oil prices, a revival in EM demand, modestly more stimulative fiscal policy, and the palliative effects from the decline in government bond yields across the region. We have also argued that the risks of a “Hard Brexit” should abate.4   Waiting... And Waiting For Inflation To Rise When the next recession rolls around, it will probably be sparked by a surge in inflation, which forces the Fed to raise interest rates much more rapidly than it has so far. Here is the thing though: Inflation is a highly lagging indicator. It usually only peaks long after a downturn has started and troughs after the recovery is well underway (Chart 11).   Consider the example of the 1960s. The unemployment rate fell below NAIRU in 1964, but it took another four years for inflation to break out in earnest (Chart 12). The U.S. unemployment rate has been below NAIRU only since 2017. The unemployment rate in Germany and Japan has been below NAIRU for much longer, yet inflation remains stubbornly low in both countries (Chart 13). Chart 12It Took An Overheated Economy For Inflation To Take Off In The Late-1960s Chart 13The U.S., Japanese, And German Economies Are At Full Employment Cheer Up This leaves us with a striking conclusion: Perhaps the next U.S. recession is not around the corner, as some grumpy economists seem to think. Perhaps this economic expansion can endure beyond 2020. The recent U.S. data has certainly been consistent with that thesis. The ISM manufacturing index rose 2.3 percentage points to 56.6 in January. New orders jumped by 6.9 percentage points to 58.2. Payroll growth has also accelerated. Real aggregate earnings are up 4.2% from a year earlier, the fastest pace since October 2015 (Chart 14). Chart 14U.S. Labor Income Growth Has Been Accelerating Housing data are showing tentative evidence of stabilization. New home sales are rebounding, while mortgage applications are back near cycle-highs (Chart 15). Chart 15Housing Activity Is Stabilizing After Last Year's Weakness Reflecting these positive developments, the Citigroup economic surprise index has jumped into positive territory (Chart 16). The New York Fed’s estimate for Q1 2019 GDP growth has also moved up to 2.4%. Chart 16U.S. Economic Data Are Beating Low Expectations Investment Conclusions Recessions and bear markets usually overlap (Chart 17). With the next recession still at least 18 months away, it is premature to turn bearish on equities. We upgraded stocks in December following the post-FOMC sell-off. Although our tactical MacroQuant model is pointing to an elevated risk of a setback over the next few weeks, we continue to see global equities finishing the year 5%-to-10% above current levels. As global growth bottoms out mid-year, the leadership role in equity markets should increasingly move away from the U.S. towards EM and Europe. Chart 17Recessions And Bear Markets Usually Overlap Bonds are a tougher call. We do not expect the Fed to raise rates again at least until June. This will limit the upside for bond yields, as well as the dollar, in the near term. Nevertheless, with the fed funds futures pricing in no rate hikes for the next few years, even a modest shift back to tightening in the second half of this year and beyond will push up bond yields, dampening total returns to fixed income. Looking beyond 2019, the case for maintaining a short duration stance in fixed-income portfolios is very strong. The longer the Fed allows the economy to overheat, the greater the eventual overshoot in inflation will be. Inflation expectations have fallen over the past few months (Chart 18). They should have risen. Ultimately, Gentle Jay Powell’s decision to press the pause button on further rate hikes means that rates will end up peaking at a higher level during this cycle than they would have otherwise. Chart 18Inflation Expectations Have Declined   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      As argued in Hyman P. Minsky, “Stabilizing an Unstable Economy,” Yale University Press, (1986). 2      Severe episodes of fiscal tightening have normally followed military demobilizations. These include the recessions following WW1, WW2, and the Korean War, and to a much lesser extent, the 1990-91 recession which was exacerbated by cuts to the defense budget at the end of the Cold War. 3      Please see Global Investment Strategy Weekly Report, “China’s Savings Problem,” dated January 25, 2019. 4      Please see Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights The current trajectory in global share prices resembles what took place in 2000 and early 2001. The early 2001 rebound in global and EM stocks lasted several weeks only, despite ongoing easing by the Federal Reserve. Corporate profits – not the Fed – was the key driver in 2001 and remains the principal driver of global and EM stocks today. EM corporate profits are set to contract this year due to China’s continuing slowdown and weakening global trade. This suggests the current EM rally is unsustainable; continue underweighting EM. In Chile, bet on lower swap rates. Continue shorting the peso but overweight the local bourse within an EM equity portfolio. Feature The dovish shift by the U.S. Federal Reserve in the past month has boosted EM risk assets and currencies. Yet, we find that in the medium and long term there is a very low correlation between Fed policy and U.S. interest rates, on the one hand, and EM financial markets on the other. Instead, EM risk assets and currencies correlate with EM/China business cycles and global trade (Chart I-1). We have not detected any improvement in China/EM growth, nor in global trade (Chart I-1). What’s more, we expect Chinese growth and world trade to continue to weaken in the coming six months. Therefore, the EM rebound and outperformance will be reversed sooner than later. Chart I-1Global Growth Indicators Do No Confirm EM Rally Please note this is the view of BCA’s Emerging Markets Strategy team. BCA’s house view is presently positive on global risk assets and global growth. The basis for this difference between our current position and that of the majority of our colleagues is the outlook for China’s growth. A Replay Of 2016 Or 2001? Most investors are betting that 2019 will be a replay of 2016, when the Fed’s dovish turn and China’s stimulus propelled the EM and global equity rallies. It is enticing to compare the current episode in financial markets to the one that occurred only three years ago. To be sure, there are a lot of similarities: the global trade slowdown driven by China/EM, selloffs in global equity and credit markets, a dovish shift in the Fed’s stance and policy stimulus in China are all reminiscent of early 2016. Not surprisingly, this has created a stampede into EM. According to the most recent Bank of America Merrill Lynch survey, as of mid-January some 29% of investors were overweight EM stocks compared to 1% overweight in the U.S., 11% underweight in the euro area and 1% underweight in Japan. By now, the overweight in EM equities is most likely even higher, given the stampede into EM assets that has occurred over the past several weeks. This stands in contrast to the 33% underweight in EM equities in January 2016. It is apparent that the majority of investors are indeed extrapolating 2016 into 2019. We hold a different view and believe China’s slowdown will be more protracted than in 2015-’16, and that EM corporate earnings are set to contract (please refer to Chart I-5 on page 6). A key distinction between China’s current policy efforts and what was implemented in 2015-‘16 is the absence of stimulus for real estate. The odds are that China’s property market will continue to languish, weighing on household and business sentiment as well as spending. Further, the efficiency of monetary transmission mechanisms could be lower today than it was in 2016 due to the regulatory tightening on both banks and non-banks. The fiscal multiplier could also be lower due to the fragile sentiment among consumers and businesses. We discussed these issues in detail in our January 17, 2019 report. Remarkably, it appears that global share prices are tracking the pattern of 1998-2001 – their trajectories are identical in terms of both magnitude and duration (Chart I-2). Chart I-2Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration That said, there are substantial differences between today and 2001 in respect to the economic backdrops in the U.S. and China. Our focal point is to demonstrate that the Fed easing is not sufficient to prop up share prices if it does not lead to a recovery in corporate earnings. We conclude that the latest rebound in EM risk assets is probably late because neither the Fed’s pause nor China’s stimulus will revive EM corporate profits in the next nine months. In terms of market action, one can draw a number of parallels between the trajectory in global share prices today and in 2000-’01. Following an exponential rally in 1999, the global equity index peaked in January 2000 (Chart I-3). The equity selloff accelerated in the last quarter of 2000, with stocks plunging in December of that year. Chart I-3Is Rebound In Global And EM Stocks Late? Oversold conditions in global share prices and the Fed’s intra-meeting 50-basis-point rate cut on January 3, 2001, generated a 7% and 15% rebound in global and EM stocks, respectively. The bounce lasted from late December 2000 until early February 2001. The current trajectory in global share prices – the rollover in late January 2018, the top formation lasting several months followed by a dramatic plunge, the bottom in late December, 2018 and the subsequent rebound – closely resemble the path global share prices took in 2000 and early 2001 (Chart I-3, top panel). The same holds true for EM share prices (Chart I-3, bottom panel). Critically, the Fed continued to cut interest rates in 2001 and 2002, yet the bear market in global equities, including EM, persisted until March 2003 (Chart I-4A and I-4B, top panels). The culprit was shrinking corporate profits (Chart I-4A and Chart I-4B, bottom panels). Chart I-4AFed Easing Did Not Help Global Stocks In 2001 Chart I-4BFed Easing Did Not Help EM Stocks In 2001 Odds are that EM earnings are set to contract this year as discussed below and shown in Chart I-5. As a result, this view bolsters our conviction that EM equities are likely to roll over soon and plunge anew in absolute terms, and certainly underperform U.S. stocks. Bottom Line: There are many economic differences between today and 2001. Our main point is that the Fed easing-inspired rally in global equities in early 2001 lasted several weeks only and was followed by a new cycle low. The key factor was not Fed policy but corporate profits. Provided our view that corporate earnings in EM and global cyclical sectors will contract this year, the rally in these segments is not sustainable regardless of Fed policy. What Drives EM: Chinese Or U.S. Growth? Predicting the outlook for China and global trade correctly is key to getting the EM call right. First, China’s credit and fiscal spending impulse leads EPS growth of companies included in the EM MSCI equity index by nine months, and it currently points to continued deceleration and contraction in EM EPS in the months ahead (Chart I-5, top panel). The average of new and backlog orders within China’s manufacturing PMI also portends a negative outlook for EM corporate earnings (Chart I-5, bottom panel). Chart I-5EM Profits Are Heading Into Contraction The primary linkage between China’s credit and fiscal spending impulse and EM profits is as follows: China impacts EM and the rest of the world via its imports. This explains why EM share prices correlate with Chinese PMI imports (Chart I-6). Chart I-6Chinese Imports And EM Equities Second, China’s imports are to a large extent driven by capital spending, especially construction. Some 85% of mainland imports are composed of various commodities, industrial goods and materials, and autos. Consumer goods make up only about 15% of imports. Major capital expenditures in general and construction, in particular, cannot be undertaken without financing. This is why the country’s credit and fiscal spending impulse leads its imports cycles (Chart I-7). This impulse is presently foreshadowing a deepening slump in mainland imports and by extension its suppliers’ revenues and profits. Chart I-7Chinese Imports Are Heading South Third, as EM shipments to China dwindle, not only will EM corporate revenues and profits disappoint but EM currencies will also depreciate. The latter bodes ill for EM U.S. dollar and local currency bonds. The basis is that exchange rate depreciation makes U.S. dollar debt more expensive to service, and also pushes up local bond yields in high-yielding EM fixed-income markets. Fourth, The majority of developing economies sell more to China than to the U.S. Remarkably, global trade and global manufacturing decelerated in 2018, even though U.S. goods imports were booming (Chart I-8). Crucially, the more recent strength in the U.S.’s intake of goods was in part due to frontloading of shipments to the U.S. before the import tariffs went into effect on January 1, 2019. Chart I-8U.S. Imports Are Very Robust Yet despite robust U.S. demand, aggregate exports of Korea, Taiwan, and Japan have done poorly and their manufacturing have slumped (Chart I-9A and Chart I-9B). Chart I-9AAsian Exports: Flirting With Contraction Chart I-9BAsian Manufacturing: Flirting With Contraction This highlights the increased significance of Chinese demand and the diminished importance of U.S. domestic demand in world trade. In particular, at $6 trillion, EM aggregate goods and services imports, including Chinese imports (but excluding China’s imports for processing and re-exporting), is greater than the combined imports of the U.S. and EU, which currently stand at $4.7 trillion ($2.5 trillion plus $2.2 trillion, respectively). Finally, the media and many investors have exaggerated the impact of U.S. tariffs on the Chinese economy. We are not implying that the tariffs are not relevant at all, or that they have not damaged sentiment among mainland businesses and households. They have. The point is that China’s exports to the U.S. constitute 3.8% of Chinese GDP only (Chart I-10). This compares to Chinese capital spending amounting to 42% of GDP and total annual credit origination and fiscal spending of 26% of GDP. Chart I-10China's Exports To U.S. Are Small (3.8% of GDP) Overall, China’s growth slowdown in 2018 was not due to its plunging shipments to the U.S. – actually, the latter were rising strongly till December due to frontloading – but due to weakness in credit origination, primarily among non-banks (shadow banking). Bottom Line: The Chinese business cycle – not the U.S.’s – is the key driver of EM share prices and currencies and more important than the Fed. EM And The Fed On the surface, it seems that EM is tracking Fed policy. To us, however, this is akin to“not seeing the forest for the trees”. Investors need to stand back and examine the medium- and long-term relationships between U.S. interest rates, DM central banks’ balance sheets, and EM financial markets. In this broader context, the following becomes apparent: There is no stable correlation between EM share prices, EM currencies and EM sovereign credit, on the one hand, and U.S. 10-year bond yields, on the other (Chart I-11). Chart I-11EM And U.S. Bond Yields: No Stable Correlation Historically, the correlation between EM share prices and the Fed funds rate has been mixed, albeit more positive than negative (Chart I-12). On this 40-year chart, we shaded the periods when EM stocks did well during periods of a rising fed funds rate. These time spans are 1983-1984, 1988-1989, 1999-2000, 2003-2007 and 2017. Chart I-12EM Stocks And Fed Funds Rate: A Historical Perspective The only two episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican peso crisis. Yet, it is essential to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Remarkably, there is also no correlation between the size and the rate of change of DM central banks’ balance sheets, on the one hand, and EM risk assets and currencies on the other. In particular, Chart I-13 validates that the annual growth rate of G4 central banks’ balance sheets does not correlate with either EM share prices or EM local currency bonds’ total returns in U.S. dollars. Chart I-13Pace Of QEs And EM: No Correlation Finally, there is a low correlation between U.S. real interest rates and the real broad trade-weighted dollar (Chart I-14). Notably, Chart I-15 illustrates that the greenback often acts as a countercyclical currency, appreciating when global growth is slowing and depreciating when the global business cycle accelerating. Please note that the dollar is shown inverted on this chart. Chart I-14The U.S. Dollar And U.S. Real Rates Chart I-15The U.S. Dollar Is Countercyclical Bottom Line: Many analysts and investors assign more significance to the Fed policy’s impact on EM risk assets than historical evidence warrants. Unless Fed policy easing coincides with EM growth recovery, the Fed’s positive impact on EM will prove to be fleeting. Investment Considerations Widespread bullish bias on EM among investors currently and a continuous slew of poor growth data in China and global trade give us the conviction to argue that the current EM rally is not sustainable. Even if the S&P 500 drifts higher, EM stocks and credit will underperform their U.S. counterparts (Chart I-16). Chart I-16Stay Short EM / Long S&P 500 The EM equity index is sitting at a major technical resistance, and a decisive break above this level will challenge our view (Chart I-17, top panel). The same holds true for many EM currencies and copper (Chart I-17, bottom panel). However, for now, we are maintaining our negative bias. Chart I-17EM Equities And Copper Are Facing Resistance Within the EM equity universe, our overweights are Brazil, Mexico, Chile, Russia, central Europe, Korea, and Thailand. Our underweights are Indonesia, India, Philippines, South Africa, and Peru. We continue to recommend shorting the following EM currency basket versus the U.S. dollar: ZAR, IDR, MYR, CLP, and KRW. The full list of our recommended positions across EM equities, local rates, credit, and currencies is available on pages 17-18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   Chile: Favor Bonds Over Stocks Local currency bonds will outperform equities in Chile over the next six to nine months (Chart II-1). Chart II-1Chile: Favor Bonds Over Stocks The central bank is raising interest rates to cap inflation. However, we believe this is misguided because China’s ongoing deceleration along with lower copper prices, will slow growth in Chile over the course of this year. In addition, the current domestic inflation dynamics are less worrisome than the central bank contends. There is ongoing debate in the policy circles of Santiago over whether the recent large net immigration wave, particularly from Venezuela, is inflationary or disinflationary. On the one hand, net immigration expands the supply of labor and puts downward pressure on wages, and hence is disinflationary (Chart II-2). On the other hand, net immigration bolsters demand, and thereby inflation. Chart II-2Chile: Labor Force Is Expanding At 2% The central bank has acknowledged both effects but has cited that the latter will overwhelm the former. We disagree with this assessment and believe that current immigration in Chile will be more disinflationary. There are a number of factors that make us believe so: Both nominal and real wage growth are cooling off rapidly (Chart II-3). This corroborates the thesis that the expanding supply of labor is capping wage increases. Chart II-3Chile: Wage Growth Is Decelerating Central banks in any country need to be concerned with rising unit labor costs and service sector inflation. Energy and food prices are beyond a central bank’s control. Monetary policy should not respond to fluctuations in these prices unless there are second-round effects on wages and other prices.  There is presently no genuine inflationary pressures in Chile. The average of Chile’s core and trimmed mean inflation rates stands at 2.5%, and service sector inflation is at 3.7% (Chart II-4). This is within the central bank’s inflation target range of 3% +/-1%. Chart II-4Chile: Inflation Is Within Target Range Finally, Chile’s exports are set to shrink due to the ongoing deceleration in China and lower copper prices (Chart II-5). With exports accounting for 30% of GDP, a negative external shock will slow domestic demand too. This will be disinflationary. Chart II-5Chilean Exports Are About To Contract The fixed-income market in Chile is pricing in rate hikes (Chart II-6). We continue to recommend receiving 3-year swap rates. Even if the central bank continues to tighten, long-term interest rates will decline, anticipating rate cuts down the road. Chart II-6Chile: Receive 3-Year Swap Rates Chilean share prices, in absolute terms, are at risk from the EM and commodities selloff. However, we recommend dedicated EM equity portfolios overweight Chile. The economy is fundamentally and structurally solid, and local equity markets are supported by large local investment pools. Importantly, unlike many other commodity producers, currency depreciation in Chile does not stop the central bank from cutting interest rates. Banco Central de Chile does not target the exchange rate and will cut rates to mitigate the adverse external shock. This will ensure that business cycle fluctuations in Chile will be milder than in other developing economies where central banks tighten to defend their currencies. This is positive for Chilean stocks versus other EM bourses. Finally, the peso is at risk of depreciation from lower copper prices. Bottom Line: Local investors should favor domestic bonds over stocks. Fixed-income traders should bet on lower three-year swap rates. Dedicated EM investors should overweight Chilean equities. Currency traders should maintain a short CLP / long USD trade. Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to further tightening emanates from stock markets and risk spreads. Through the next couple of years U.S. long bonds will strongly outperform German bunds… …and USD/EUR will trend lower. Since October 2017, no stock market rally or sell-off has lasted more than three months. Overweight equities tactically, but don’t get too comfortable. The broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. Feature More than a decade has passed since the Global Financial Crisis. Yet through the past ten years, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then swiftly reverse course. 2019 is a pivotal year for monetary policy because it will answer a fundamental question: will the 2 percent limit for monetary tightening that has held since 2008 continue to hold, or finally break? (Chart of the Week). The answer will have a huge bearing on European investment strategy for equities, bonds and currencies. Chart of the WeekSince 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent... So Far A History Of Policy Reversals Swedish interest rates peaked near 5 percent in 2008 before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Admittedly, Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. But on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening of only 1 percent; Korea could manage just 1.25 percent (Chart I-2); the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again.   Chart I-2Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent The Federal Reserve has sequentially raised interest rates by 2 percent, and guess what? It has just decided to take a breather! Last week, Chairman Jay Powell was asked the question as plainly as possible: is the next move in interest rates as likely to be up as down? And his answer: “we don’t have a strong prior… we will patiently wait and let the data clarify.”1 There is no requirement at BCA for strategists to agree. In fact, the opposite is true in that we encourage independent thinking and diverse ways of looking at the world. BCA’s house view is that the Fed will resume its sequential hiking later in the year. But I believe this takes a too rosy view on the global financial system’s capacity to tolerate further tightening. The Vulnerability Is In Stock Markets And Risk Spreads   Monetary policy operates on an economy by adjusting its financial conditions: its bond yields, credit availability, currency, stock market, and risk spreads. And the neutral monetary policy stance – the so-called ‘neutral real interest rate’ – is the policy stance consistent with the economy growing at trend. In the past, a simple rule of thumb was that real rates, over time, should approximate to the real growth in the economy. But some studies argue that the neutral real rate may now be close to zero. All the Fed has done is bring the real interest rate out of negative territory to barely above zero. Yet its recent hikes have been blamed for extreme volatility in stock markets and risk spreads. Last week, Powell acknowledged that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” Furthermore, “the policy stance is now in the range of the Committee’s estimates of neutral… and when you get to that (neutral) range we have to put aside our own priors and let the data speak to us.” All of which raises a salutary observation from my colleague Martin Barnes, BCA Chief Economist: if a real interest rate that is barely above zero is enough to trigger extreme market volatility and threaten the economic expansion, then the system is much more vulnerable than generally assumed.2  Martin has hit the nail on the head. At the current level of tightening, the system is much more vulnerable than generally assumed. But the vulnerable components of financial conditions are not bond yields, credit availability, or currency; the vulnerability emanates from stock markets and risk spreads, and specifically their potential for extreme volatility. Previous reports have focused on the source of this vulnerability. To recap, at low yields, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But when the 10-year global bond yield rises back to around 2 percent, the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets.3 Put simply, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. The consequent plunge in risk-asset prices aggressively tightens financial conditions and thereby sets an unusually low ceiling for nominal interest rates and bond yields. This dynamic proved to be the major feature of the financial market landscape in 2018 and will loom large in 2019 too. It also solves the riddle as to why the neutral real rate may now be close to zero. An unusually low ceiling for the nominal interest rate combined with inflation hovering around 2 percent, translates into a neutral real interest rate that is not much higher than zero. The Investment Implications When the Riksbank paused after its near 2 percent of hiking, it proved to be a good structural entry point for Swedish long bonds, and a good structural exit point for the Swedish krona (Chart I-3 and Chart I-4). Likewise, when the Reserve Bank of Australia paused after its near 2 percent of hiking, it was an excellent moment to buy Australian long bonds and to sell the Australian dollar (Chart I-5 and Chart I-6). Chart I-3When The Riksbank Paused, It Was A Good Structural Entry Point In To Swedish Bonds... Chart I-4...And A Good Structural Exit Point Out Of The Swedish Krona Chart I-5When The RBA Paused, It Was A Good Structural Entry Point In To Australian Bonds... Chart I-6...And A Good Structural Exit Point Out Of The Australian Dollar Will the the 2 percent limit for monetary tightening that has held since 2008 continue to hold? If, as we expect, the answer is yes the implication is that through the next couple of years U.S. long bonds will strongly outperform German bunds. Over the same time frame, USD/EUR will trend lower (Chart I-7 and Chart I-8).  Chart I-7A Good Structural Entry Point In To Long T-Bonds/Short Bunds Chart I-8A Good Structural Exit Point Out Of USD/EUR Finally, as regards the broad stock market, a quick glance at the MSCI all country world index shows a striking feature. Since October 2017, no rally or sell-off has lasted more than three months (Chart I-9). Given the current highly non-linear relationship between equities and bond yields, this pattern is set to continue. Chart I-9Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months In essence, the broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. The current stance is tactically long, but don’t get too comfortable! Fractal Trading System* The sharp recent rally in government bonds has hit a point where tight liquidity conditions could trigger a temporary reversal. Accordingly, the 65-day trade is to go short 30-year T-bonds, setting a profit target at 3 percent with a symmetrical stop-loss. All of the five other open positions are in healthy profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com  * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 The Federal Reserve has raised the federal funds rate by a total of 2.25 percent comprising an isolated 0.25 percent hike at the end of 2015 and a sequential 2 percent hike from December 2016 through December 2018. 2 Please see the BCA Special Report “A Grumpy View Of The Outlook” January 28, 2019 available at www.bcaresearch.com 3 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com  Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights So What? The late-cycle rally faces non-trivial political hurdles. Why? The rally is based on a too-sanguine view of the Fed, China, and the trade war. Other issues – like Brexit and the U.S. border showdown – are also problematic. Venezuela still has the potential to push oil prices sharply upwards. Feature All is well. Global equities are on the path of recovery, as should be the case at the end of an economic cycle. The U.S. S&P 500 has gained 16% since the bottom on December 24, with healthy technicals suggesting a breakout is ahead (Chart 1). The S&P 500 may be entering one of its typical late-cycle rallies, which tend to be the second best-performing decile of a bull market (Chart 2).1 Meanwhile, emerging market equities and currencies are outperforming developed market peers (Chart 3), a reversal from 2018 Chart 1Late Cycle Rally Ahead?   Chart 3...As Does Current Global Outperformance Typically, global risk assets outperform American risk assets at the end of an economic cycle. While institutional investors can use these rallies to lighten the load ahead of a recession, most investors cannot afford to miss such a rally. As such, BCA (and others) are calling for investors to play what is expected to be a yearlong rally in global risk assets and the S&P 500. Our view at BCA Geopolitical Strategy is more cautious, perhaps because it is informed by a methodological bias rooted in geopolitics. We believe that the reversal in U.S. outperformance relative to global risk assets rests on three pillars: The Federal Reserve remains dovish throughout 2019; China begins a major reflationary effort;  The U.S.-China tariff truce results in a trade deal. In addition, a consensus is emerging that a “no deal” Brexit will not occur, that U.S. polarization cannot get worse, and that President Trump eschews foreign interventionism. While we hold a nuanced view on each of these assertions, the mix is far less bullish than investors may think. We see a witches’ brew of factors that is murky at best and bearish at worst. The Three Pillars Of The Bullish View Before we turn to geopolitics, let us examine the three pillars underpinning the bullish view. Our colleague Peter Berezin, BCA’s Chief Global Strategist, remains bullish on the U.S. economy and expects the Fed to resume hiking rates by mid-year.2 The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 4). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 5). Chart 4Little Sign Of A Looming Credit Crunch Chart 5Capex Plans Still Solid It is no surprise that the BCA Fed Monitor continues to suggest that “tighter monetary policy is required” (Chart 6). This is a far cry from 2016, when our indicator was in deeply “tightening” territory and the Fed paused for 12 months. If we compare 2019 to 2016, it is difficult to see how the market expectation of 4.72 bps of rate cuts will occur over the next 12 months (Chart 7). Of the three components that make up the BCA Fed Monitor, only the financial conditions have fallen into “easing required” territory (Chart 8), and they are already shifting back to “tightening required” territory with the stock market rally underway (Chart 9). Chart 6A Hawkish Fed Is Needed Chart 8BCA Fed Monitor Calls For Tighter Policy Chart 9Financial Conditions Starting To Ease In addition, in 2016 the Fed was not contracting its balance sheet. Today it is doing so, although the pace has moderated. As such, the Fed’s rate hike pause is occurring amidst an ongoing effort to normalize monetary policy and to transfer rate risks back to the private sector. By chance, this is also occurring at a time when the Treasury Department must issue more debt to cover a larger deficit, a process that could significantly pull U.S. rates higher and, by extension, yields on assets further down the risk curve. This would be a particular problem for global risk assets given the exposure of several EM economies to dollar-denominated debt.  The bottom line for investors is that a rate hike pause is not a pause in the overall hawkish policy of the U.S. Fed, which acts as a global central bank. The fall in the amount of dollars available for the international financial system acts as a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, BCA’s Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart 10). Chart 10Deteriorating Excess Liquidity Hurts Global Growth Our muted view on Chinese reflation is unnecessary to repeat here. There is no doubt that Chinese policymakers are stimulating the economy, but the question is whether they are willing to pull the credit lever as aggressively as they have done in the past (Chart 11).So far, all of the evidence we have reviewed point to a cautious effort to stabilize growth, not reflate the entire planetary economy as Beijing did in 2016. If our BCA House View on the Fed is correct, a tepid Chinese effort to stimulate the domestic economy will fall short of lighting the flame of a global risk rally in 2019. Chart 11Compare Any Stimulus To Previous Efforts The BCA China Play Index, which in the past has tracked EM vs. DM equity outperformance, is sending mixed signals today (Chart 12). Enthusiasm for global risk assets has not been confirmed by the most China-sensitive plays. Chart 12Mixed Signals From China-Sensitive Plays Finally, there is the trade truce that should produce a trade deal. The logic is clear: President Trump sets aside the political constraints working against a deal and focuses on ensuring that he wins 2020 by avoiding a recession. The near bear market in the S&P 500 was a game changer that focused the White House on averting any further downside to markets and the economy from the trade war. But if the current rally proves that the selloff in December was a temporary pullback, the White House may be emboldened to play hard-to-get with China. After all, the electorate is generally supportive of getting tough on China (Chart 13) and there is no demand from either Trump voters or Democrats for a quick deal. The Fed pause and lower oil prices also give Trump some space to push negotiations a bit harder. Already there are leaks from the negotiations that the U.S. is asking for a lot from China, which could prolong the talks. This includes genuine structural changes to the economic relationship that would address long-standing U.S. concerns of forced technology transfers, intellectual property theft, and foreign investor access to the Chinese domestic market. It also includes U.S. demands that these changes be verifiable and enforceable. China is likely to balk at some of the U.S. demands, particularly if the U.S. is indeed pushing for regular reviews of China’s progress, a condition that implicitly creates a hierarchy between the two economies and would thus represent a loss of face for Beijing.3 Table 1 presents our latest expectations of where the U.S. and China will be on March 1. We assign only 10% each to “black and white” outcomes, a “Grand Compromise” and “No deal, with major escalation.” The remaining 80% is divided between “mushy” outcomes, including a 25% probability that negotiations simply continue. Table 1Updated U.S.-China Trade War Probabilities How would the market react to such uncertain outcomes? We think that almost anything other than a “Grand Compromise” would be greeted with limited relief, if not outright market correction. A vaguely positive meeting between Presidents Trump and Xi, and a memorandum of understanding, would not remove long-term risks in the relationship, especially if the parallel “tech war” is not resolved. On top of the ongoing U.S.-China negotiations, there is one remaining trade issue that investors should keep in mind: auto tariffs. The Section 232 investigation into whether auto imports are a national security threat is ongoing and U.S. authorities are expected to present their conclusions on February 17. We fear that the Trump administration could still stage a surprise and impose tariffs on auto imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production within the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. An extended truce with China could provide the opportunity. The Trump administration may not have the stomach for a long-term trade war with Europe, but the timing of this decision could upset the market’s perception of Trump’s commitment to free trade once again. Bottom Line: The conventional narrative is that global markets are experiencing a late-cycle rally, one that is worth playing given its usual duration and amplitude. This view rests on three pillars: that the Fed has backed off from tightening, that China is stimulating in earnest, and that the trade deal will produce a definitive outcome. We fear that all three pillars are shaky. First, the Fed is not easing. Its balance sheet contraction process, which is ongoing, is a form of tightening. And the U.S. economy remains healthy. As such, the expectation of a 12-month Fed pause is overly optimistic. Second, China is stimulating, but only tepidly. Third, “black and white,” definitive outcomes are unlikely in the U.S.-China negotiations. In fact, more protectionism could be around the corner if U.S.-China tech issues continue to flare or if the U.S. announces the conclusion of its investigation into auto imports. Geopolitical Factors To Monitor Aside from shaky pillars, markets will also have to contend with several uncertain geopolitical processes this year. While we are not necessarily bearish on each one, we are concerned that the collective investment community is overly bullish. Take Brexit. We agree with the conventional view that the chances of a no-deal Brexit outcome are below 10%. Political betting markets have only priced in an actual exit on March 29, which is in ink in British legislation, at just above 30% (Chart 14). Chart 14Online Betters Expect A Brexit Delay The problem is not with the conventional view but with its timing. While Prime Minister Theresa May will ultimately be forced to extend the Article 50 deadline, it may take a lot of brinkmanship and eleventh hour negotiations to do so. Getting from here – collective bullishness – to there – an actual extension of Article 50 – may require a downturn in GBP/USD or other U.K. assets. Furthermore, several scenarios could produce a downturn in GBP/USD (Diagram 1). For example, the Labour Party remains neck-and-neck with the Tories in the polls, despite being led by the most left-leaning leader since the 1970s. Although a new election that produces a Labour government would likely reduce the odds of Brexit eventually occurring, it would raise the odds of Corbyn pursuing unorthodox economic policy while also trying to negotiate his own version of Brexit with the EU. Diagram 1Brexit: The Path To Salvation Remains Fraught With Dangers The point is that it is tough to recommend that investors close their eyes and buy GBP/USD, no matter how cheap the currency may look, unless one has a very long time horizon and a high threshold for pain. The second issue where we take a more nuanced position is the ongoing U.S. executive-legislative standoff over the border. The government shutdown is only on pause until February 15. The House Democrats are demanding that a solution be found by Friday, February 8 if it is to be voted on in time. Meanwhile President Trump’s popularity is in the doldrums (Chart 15). His supporters note that President Reagan was even less popular at this point in his term, but that is because unemployment hit 10.4% in January 1983 (Chart 16). The grave risk for President Trump is that he is as unpopular as Reagan, even though unemployment is at 4% and the U.S. economy is on fire. Chart 15President Trump Is Unpopular... Chart 16...And It Can't Be Blamed On Unemployment As such, the real risk is not another shutdown, but rather political dysfunction in Congress that imperils the legislative process. The current two-year budget deal, which raised spending levels in January 2018, is set to expire when the FY2019 ends. Democrats and Trump have to come to an agreement to avert the “stimulus cliff” expected in 2020 (Chart 17). If they cannot conclude the border issue and the FY2019 appropriations, then Trump may declare a national emergency (or act unilaterally in other ways) and spark a new conflict with the courts. He could also threaten not to raise the debt ceiling in spring or summer. This is not an atmosphere in which a FY2020 deal looks very easy. Chart 17Stimulus Cliff Ahead Ultimately, we expect Democrats to succumb to the pressure from their voters for more spending. But a total failure to cooperate is a risk. Furthermore, the greatest political risk in the U.S. is that the 2020 election will not be contested on the same issues as in 2016: trade and immigration. Instead, income inequality is rearing its head, as Democratic candidates jostle for attention and as they test various messages on focus groups. If income inequality catches fire as the issue of 2020, we will know it soon. And it may begin to impact the markets as Democrats begin to campaign on, for instance, reversing President Trump’s income tax cuts. While the market may ignore headline election risks for some time, we do not think that non-financial corporates can do the same. Any hint that President Trump’s pro-business policies will be reversed could send shivers down the spines of CEOs and negatively impact capex intentions, hurting the real economy well before the next election. Finally, there is the issue of foreign policy. President Trump has abandoned his maximum pressure tactic on Iran and has begun withdrawing the remaining troops in the Middle East. These trends are likely to continue in 2019 as President Trump focuses on China and lesser issues like Venezuela. There is one important area of alignment between him and the defense and intelligence community, notwithstanding recent scuffles: less focus on the Middle East means more focus on Asia and specifically China. However, President Trump is facing a dilemma. Despite an extraordinary economic performance, his popularity remains in the doldrums. When faced with similar situations in the past, presidents far more orthodox than Trump have sought relevance abroad, by means of military interventions. A convenient opportunity has presented itself in Venezuela, where a revolution against Chavismo could give the U.S. an opening to intervene. On paper, we see how such a scenario could look appealing for a quick, and relatively painless, intervention. The problem is that it could also get messy and, in the analysis of BCA’s Commodity & Energy Strategy, raise oil prices to nearly $100 per barrel by mid-year if a total loss of Venezuelan production ensues (Chart 18). This is a non-negligible risk. Chart 18A Venezuela Collapse Could Send Brent Crude Prices Toward $100/Bbl Bottom Line: Geopolitical risks still abound. We are not alarmist. However, there is little reason to believe that Brexit, U.S. polarization, U.S.-China tensions, or a potential U.S. intervention in Venezuela will end painlessly for the market. An unpopular U.S. president is seeking to remain relevant and a global populist wave is continuing to create unorthodox and anti-establishment policy prescriptions. Given that the current rally is supported by three shaky pillars, any one of these geopolitical risks could catalyze a relapse, the history of late-cycle rallies be damned.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Please see BCA U.S. Investment Strategy Weekly Report, “Late-Cycle Blues,” dated October 29, 2018, available at usis.bcaresearch.com. 2      Please see BCA Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019, available at gis.bcaresearch.com. 3      Please see Reuters, “Exclusive: U.S. demands regular review of China trade reform,” dated January 18, 2019, available at reuters.com.   Geopolitical Calendar

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