Financial Markets

Special Report

Highlights Investors have piled into private equity (PE) in recent years, pushing assets under management (AUM) up to an all-time high of $3 trillion. However, there are increasing concerns about the outlook for the asset class over the next few years. In this report, we look at the fundraising and deal environment for PE, analyze historical risk-adjusted returns in comparison to traditional assets, and suggest how investors can optimize their PE allocation. Private equity and its two major sub-categories, buyouts and growth capital, have generated annualized returns of 13.4%, 13.7%, and 15.0% respectively over the past 32 years, significantly beating the returns from global equities and small-cap stocks of 8.4% and 9.1%. But the current environment is tougher. Dry powder (funds raised but not yet invested) exceeds $1 trillion. PE managers face increased competition from other investors and from companies with large cash balances looking to make acquisitions. Funds raised at the peak of bull markets have a higher probability of underperforming. The next two vintage years (2018 and 2019) face headwinds to making good returns, because of high entry valuations and a rising cost of borrowing. Manager selection is critical for a successful private-equity program. Top-quartile PE funds have outperformed second-quartile funds by as much as 8% a year over the past two decades. Feature Introduction The private equity (PE) market has grown more than five-fold since 2000, lifting assets under management from $577 billion to $2.97 trillion. However, its share of the private investment market has declined from 82% to 58% (Chart 1). Private equity and venture capital investing is said to date back to 1901 when J.P. Morgan purchased Carnegie Steel Co from Andrew Carnegie and Henry Philips for $480 million. The industry has evolved significantly over the years, and now encompasses a wide range of sub-strategies, offering investors a spectrum of exposures with very different risk/return profiles. Chart 1Private Equity Is A $3 Trillion Market Compared to public equity, private equity investing is harder because of: 1) long-term illiquidity, whereas public equities can be bought and sold quickly, 2) limited information on target companies, 3) the lack of a clear price discovery function, meaning that pricing in private markets depends heavily on negotiations, 4) less separation between ownership and control - finance providers in PE tend to be managers too. The PE space has matured over the years, and this is clearly seen in the compression of returns. However, many investors remain bullish on this asset class because of its historically attractive risk-adjusted return, and ability to diversify traditional portfolios. As of mid-2017, the median net return of the PE holdings of public pensions globally over the previous 10 years was 8.5% compared to 4.2% for public equities, 4.5% for real estate, and 5.2% for fixed income.1 In this report, we analyze in detail the PE market, with an overview of the fundraising cycle, deal environment, and exit channels. We include in-depth analysis of historical returns from the private equity market in aggregate, and from its two largest sub-categories, buyouts and growth capital. We end by listing the key risks for limited partners (LPs - the investors in PE funds), and include a brief note on private-equity secondary investing. Our key conclusions are: Private equity, including buyouts and growth capital, has had exceptionally good returns over the past three decades, but has been on a structural downtrend as competition has increased. Buyout funds generate a negative skew and moderate kurtosis, whereas growth capital tends to have a larger kurtosis and positive skew. Funds raised at the peak of bull markets have a greater probability of underperforming given their higher entry valuations. This is likely to be the case for funds raised over the next 18 months. The current economic cycle has produced fewer home-run deals - in 2002-2005, 35% of deals produced returns of 3x invested capital, but this fell to 20% in the 2010-2013 period. Megacap buyout funds produce the best returns, but this comes with significantly higher volatility pushing down the risk-adjusted return. These larger funds experience larger negative skew and kurtosis driven by greater use of leverage. Entry valuations of investments made by PE funds have been steadily rising, and so has leverage: the median debt/EBITDA has reached 5.5x. As multiples keep rising, general partners (GPs - the fund managers) have to make up the difference with equity infusion. Top-quartile managers have significantly outperformed. Third-quartile managers struggled even to outperform global equities, and fourth quartile managers failed to preserve their initial capital. The secondary PE market is growing. It provides access to mature portfolio assets deeper into their distributions phase, which reduces the duration of the LP's investment. Fundraising, Deals, And Exits Private equity investing consists of many different sub-categories (Chart 2) that differ in value creation techniques and the maturity of target companies. Buyouts and growth capital are over 90% of the total. Buyouts2 invest in established companies, usually with the intention of improving operations and financials. There is usually substantial use of leverage. Growth capital3 takes significant minority positions in profitable yet still maturing companies mostly without the use of leverage. Secondary funds acquire stakes in PE funds from other LPs. Co-investment funds make minority investments alongside a buyout, recapitalization, or any other non-controlling investment. Turnaround funds aim to revitalize companies that face operational difficulties. Chart 2Buyouts & Growth Capital Are 90% Of PE Private-equity firms raised $701 billion in 2017, making the past five years the strongest period for fundraising in history, with a total of $3.2 trillion (Chart 3). Additionally, more than two-thirds of the funds which closed in 2017 met or exceeded their target amounts, and 39% took less than a year to close. The last time fundraising peaked was in 2008, right in the middle of the last recession. However, since 2009, fundraising for buyouts has dropped from 85% to 70% of the aggregate for private equity, with growth capital picking up the slack, rising from 8% to 21%. As fundraising has gotten stronger, PE firms have been raising larger funds.4 These megafunds (with AUM greater than $5 billion) raised $174 billion in 2017, or 58% of that year's total buyout volume, a steep increase from $90 billion in 2016. For investment institutions with large amounts of capital to deploy, megafunds are an attractive and efficient outlet. Another reason for the very strong fundraising environment has been quick follow-up funds, where GPs race to launch new funds before predecessor funds have matured. Historically GPs have waited an average of 62 months between closing one fund and starting the next, but this has come down to 40 months in the past five years. With fundraising so strong, GPs are under pressure to deploy this capital wisely. Global PE deal volume increased by 14% in 2017, surpassing $1.2 trillion (Chart 4). But global deal count has been on the decline since 2015. Along with larger funds being raised, the average deal size in the private market has been rising steadily since the Global Financial Crisis (GFC). Despite increasing deal activity, the sheer volume of fundraising in recent years has led to massive accumulation of dry powder,5 which currently stands at $1.03 trillion. After 2008, dry powder as a percentage of AUM (Chart 5) was on a downward trend because of increased acquisition activity due to attractive valuations following the GFC. But this bottomed in 2012 at 29% and had risen to 35% at the end of 2017. If this level of dry powder accumulation continues, GPs will be forced to reduce hurdle rates and deploy capital into less attractive deals. Chart 3$3.2 Trillion Raised in 5 Years Chart 4Rising Deal Size Chart 5Harder To Find Attractive Deals Another reason for dry powder accumulation is increasing competition for deals both within the private equity market, and from external sources. The number of private equity funds is at an all-time high of 7,775.6 The external competition comes largely from corporate buyers with large cash balances looking for inorganic growth. Corporations have two advantages over PE firms: 1) potential built-in synergies when it comes to integrating the target, giving them the ability to pay a higher price, and 2) a lower cost of capital. An increasing number of corporations have been setting up corporate venture-capital units (Chart 6) to focus on acquisition-led growth. In 2017, there were 38,479 companies bought and sold globally for a total value of $3.3 trillion. But, private equity's share of this market was just 13% by deal value and 8% by deal count (Chart 7). Looking forward, PE funds are likely to act more aggressively and take a larger share of the market, as they did in 2006-2007. In order to increase their share of global deal activity, private-equity funds need to look at more strategic ways to pick up assets: Chart 6Corporations Setting Up VCs Chart 7Buyouts Only A Tiny Player In Global M&A Zombie Assets: Assets (portfolio companies) belonging to funds that last raised initial capital between 2003 and 2008 but have not executed a deal since 2015. Currently there are over 100 such companies that are possible targets for takeover in 2018-2019. Carve-Outs: Over the past few years, one in five deals in the U.S. has come from corporations disposing of non-core assets.7 This provides a steady deal flow for buyout and turnaround funds. Public To Private: As multiples in private markets converge with those in public markets, more and more publicly listed companies are being taken private, and this market has doubled since 2016 (Chart 8). Additionally, lenders have become more comfortable about financing these high-value transactions. Buy & Build/Add-Ons: Purchasing cheaper small assets and adding them to existing large established platform companies. This in turn transforms a group of smaller companies at lesser multiples into a larger corporation with a premium valuation. Add-ons made up one-third of deals a decade ago, but that has now reached 50%. But, since such deals are smaller in terms of dollar value, they make up less than 25% of the total deal volume. Finally, PE firms have also been increasing the holding period of the assets in their portfolio. The median holding period before the GFC was four years, and this has now increased to over five years (Chart 9). Additionally, private equity firms exited 40% of all deals in fewer than three years, but now these quick-flips have fallen to only 20%. This is partly a response to increased competition: GPs are skeptical about finding new attractive deals, and this forces them to hold onto assets for as long as possible. Additionally, the new U.S. tax code has increased from one to three years the threshold period for carry to be treated as capital gain with a lower tax rate, rather than taxed as ordinary income. With fundraising on fire but deal activity struggling to keep pace, the final pillar for a successful private equity program is the exit environment. Global PE-backed exits have been flat for the past two years at around $500 billion, with the deal count between 2,500 and 3,000 (Chart 10). The rise in exit activity in 2015 was fuelled by PE firms looking to exit portfolio companies acquired before the financial crisis. By 2017, the dynamic had changed since more than 80% of exits that year were companies acquired in 2009 or later. Finally, dividend recapitalizations8 reached $42 billion in 2017, but these are heavily dependent on an accommodative debt market and positive environment for high-yield bonds. With rising rates, dividend recapitalization, and other forms of special dividends or distributions that require borrowing, become harder to execute. Chart 8Public-To-Private Activity Chart 9Longer Holding Periods Chart 10Global PE Exits Are Healthy Historical Returns Before we look at the past risk-return profile of investing in this asset class, a note on the data used in this report. All return data are based on the Cambridge Associates Private Investment Benchmarks.9 We are satisfied with the methodology used and the format in which the returns are presented. The provider has taken sufficient steps to minimize survivorship bias. For more details on the data methodology, please see the Appendix. What can investors expect in terms of risk-return exposure from this asset class? Looking at Table 1, private equity and its sub-strategies have comfortably outperformed global equities, with lower volatility, over the past 32 years. Even after statistically adjusting returns for stale pricing,10 volatility for aggregate private equity and buyouts remains lower than for global equities and small-cap stocks. On the other hand, growth capital has had realized volatility greater than that of global equities, but with a significantly higher return; it is still the more attractive investment on a risk-adjusted basis. However, the significantly lower realized volatility of PE in aggregate, and buyout funds in particular, compared to growth capital makes them more attractive investments. Additionally, venture capital experienced volatility of close to 42%, more than double that of small-cap stocks, making it very unattractive from a risk-adjusted perspective. Table 1Risk-Return Spectrum However, comparing the performance of PE with that of publicly traded assets could be misleading given the uncertain timing of cash inflows and outflows from private equity programs. Therefore, we also show the Public Market Equivalent11 (PME) to adjust public-market indices for uncertain cash flow streams. Looking at Tables 2-4, we can see that private equity still outperforms equity indices on a PME basis over different time frames. Table 2Private Equity PME Analysis Table 3Buyout PME Analysis Table 4Growth Capital PME Analysis Another unique characteristic of private-market returns is the J-curve effect where investments in private markets take time to bear fruit, and fees are initially based on committed capital rather than invested capital. In addition, the biggest cash flows will be received towards the end, so the returns for the first few years can be misleading. IRR will remain negative until the point when distributions at least match contributions (the payback point). Given the non-linear return distribution of alternative assets such as PE and venture capital, risk analysis is not complete without skewness and kurtosis. Investing in buyout funds generates a negative skew and a moderate level of kurtosis, which means that investors can expect more stable, predictable returns, closer to a normal distribution. However, growth capital tends to have larger kurtosis and positive skew, thereby a higher probability of large upside gains. Since buyout capital structures tend to be more heavily geared, there is a higher skew towards negative returns driven by the leverage effect. Venture capital exhibits a return distribution similar to growth capital, where a few portfolio companies produce large positive returns given the start-up nature of its targets. PE returns remain attractive but, as with other alternative asset classes, performance has been on a downward trend (Chart 11) driven by increased competition. In the 1980s and 1990s, buyout firms exploited the poor performance of large U.S. conglomerates by acquiring underperforming divisions and using leverage. In the early 2000s, funds took advantage of the stock market rise, fuelled by low rates and levered returns. Within the structural downtrend in returns, PE has had a cyclical profile just like public equities. During bull markets there are more exits at higher valuations, and larger distributions to LPs. However, funds raised in bull markets have a higher probability of underperforming given their higher entry valuations. Looking forward, funds from recent vintages that are halfway through their life are likely to be able to take advantage of current tailwinds to build value and exit at the top. However, funds raised in the next two years will have to deal with high entry valuations and a possible increase in the cost of borrowing. There have been fewer write-offs and deals with capital impairments in the post-2009 period than in the years after the 2001 recession. However, the current economic cycle has produced fewer of the home-run deals that really drive PE performance. For example, in 2002-2005, 35% of deals produced returns of 3x invested capital or better, and more than 50% generated multiples of 2x or better. For the period 2010-2013, the equivalent percentages were 20% and 42% respectively. Looking at Chart 12, we can see that PE, buyout, and growth capital funds outperformed global equities and small-cap equities during recessions and equity bear markets. Chart 11Private Vs. Public Equity Chart 12Recession & Bear Markets Return persistence is the ability of top-performing manager to repeat the strong performance in their follow-up funds. In the PE industry, some large firms have proved able to repeat top-ranked performance time after time across multiple funds. We believe this is likely a function of their network of contacts that gives them access to proprietary deal flows. However, there are three factors that may be creating a spurious correlation here: 1) GPs tend to raise new funds 2-5 years into the life of an existing fund, thus creating overlapping structures of successive funds that are exposed to similar market environments, 2) investments in some portfolio companies are split between successive funds which induces a spurious patterns of performance persistence, 3) much of the top-quartile performance persistence came during periods of low competition. There is also a relationship between holding period and performance, whereby funds that hold onto portfolio companies for longer have lower performance, while quick-flips perform better. Funds have an incentive to exit successful investments earlier to show a good track record, and to extend the holding period of unsuccessful ones hoping for a better outcome. There is an intrinsic cyclicality in this relationship: in bear markets when valuations are low, funds will hold off from selling their assets in the hope of a better time to sell. Table 5 show the average returns LPs can expect from investing in companies with a specific sector focus. But, this comes with a large amount of idiosyncratic firm- and sector-specific risk; this tends to have a larger impact on buyouts than on venture capital which is already very industry focused. Geographic diversification gives investors access to different economic cycles and levels of market maturity across the globe. In the last recession, PE performance was very poor in some regions, while not that bad in others. There has been a clear cyclical pattern for U.S. versus ex-U.S. performance over the past 30 years, closely linked to the relative growth rates in the underlying economies (Chart 13). Table 5Returns By Sector Exposure Chart 14 shows that from Q3 1998 to Q4 2000 relative performance between buyout and growth capital funds tended to move along with the interest-rate trajectory - the former benefits from falling rates which lower the cost of borrowing. Additionally, looking at median net IRR for funds by vintage year, we see that buyouts outperformed growth capital in 17 out of the 21 years (Chart 15). This was driven by stronger distributions to buyout fund LPs. Additionally; it was achieved with a fairly similar standard deviation of fund performance across vintage years. Within the buyout space, the median U.S.-focused buyout fund outperformed its ex-U.S. counterpart only in 2004-2012. Chart 13U.S. Vs. Rest Of The World Chart 14Impact Of Rising Rates Chart 15Buyouts Vs Growth Capital Finally, when allocating to private-equity and especially buyout funds, investors have a choice between different deal sizes (small to megacap). Looking at Table 6, it is clear that megacap buyout funds have been able to produce the best returns, but this came with significantly higher volatility, pushing down risk-adjusted returns. Additionally, these megacap deals have a larger negative skew and kurtosis - investors should expect a higher probability of large negative returns. Looking at performance in recessions, one can find a relationship between the nature of the downturn and the performance of different buyout deal sizes. For example, during the 2001 recession, the smallest deal sizes produced the worst performance because smaller-cap tech stocks suffered in the aftermath of the dotcom bust. During the 2007-2009 recession, the worst hit were larger buyout deals because of the damage done to the credit market. An analysis of PE would not be complete without a discussion of valuations. The average deal size has risen by 25% since 2009: two-thirds of this increase is due to rising multiples, and the remaining one-third is organic (Chart 16). Median EV/EBITDA has risen from 5.6x in 2009 to 10.7x in 2017. Leverage levels have been rising alongside multiples, and so lenders will be more hesitant to offer debt financing for deals. GPs will have to to make up the funding shortage with equity infusion, and this leads to a decrease in IRR. Additionally, covenant-lite loans have been increasing since 2012 and are now 75% of overall loan volume in the U.S. The percentage of listed companies globally valued at more than 11x EV/EBITDA rose from 20% in 2012 to 54% in 2016. Table 6Size Matters Chart 16Private Equity Is Expensive Lastly, return dispersion is much larger for private-market investments compared to public markets, because of the more active nature of the investment process. If an LP had consistently picked only top-quartile managers from 2000, they would have outperformed second-quartile managers by an impressive 7.7% (Chart 17) a year. Top-quartile managers generated these higher returns with only a trivial increase in volatility, thereby producing far superior risk-adjusted returns. Additionally, skewness and kurtosis measures show no significant deterioration (Table 7). Third-quartile managers struggled even to outperform global equities, and fourth-quartile managers failed even to preserve initial capital. Therefore, manager selection is critical to building a successful private-equity program. Over the past decade, there has been clear compression in fees charged by private equity firms (Chart 18). Management fees tend to differ significantly between the smallest and largest funds; but they are fairly consistent at about 1.975% for funds with AUM between $100 million and $1.9 billion. Chart 17Manager Selection Is Critical Table 7Large Dispersion Chart 18Fee Compression? Risks In Private Equity Chart 19Strong Distributions The long-term investment horizon, illiquid nature, and unique structure of PE bring logistical challenges and unique risks. Given the erratic nature of capital draw-downs by GPs, some LPs might be unable to service capital calls which leads to their defaulting on their obligations. In this case, investors are exposed to funding risk and could lose their entire investment in the fund and all the capital already paid in. LPs tend to use distributions from a mature fund to finance capital calls of younger funds. But this may not be feasible in a slowdown when exits dry up and distributions slow, forcing LPs to raise additional capital from external sources12 for commitments. Many investors run an over-commitment strategy to avoid being under-exposed to their strategic allocation. The strong equity bull market has increased overall portfolio values, meaning that LPs have received large distributions, which have been double contributions since 2013 (Chart 19). Therefore, the net asset value (NAV) of PE holdings has not grown, and allocations even contracted in 2017, forcing LPs to keep plowing gains back into their programs to maintain the target allocation. Investors also face significant liquidity risk. GPs could be forced to sell portfolio companies in the secondary market at a discount to NAV, given the illiquid nature of the market. The secondary market tends to be very cyclical and is likely to experience a deal drought, as seen during the last financial crisis. Market risk is the impact of volatile markets on the quarterly changes in NAV of the portfolio. Capital risk relates to the realization value of the private-equity investments. There is a risk of a private-equity investment going bust and losing all its value. Holding a portfolio of funds exposed to many different companies can reduce this risk and generate a statistical distribution skewed towards positive returns. Additionally, diversification over multiple vintage years should create a right-skewed distribution that minimizes long-term capital risk. A Note On Private Equity Secondaries Chart 20Secondaries: Faster Return But Smaller Upside The secondary market for LPs' private-equity investments is growing. Direct secondaries are the sale of an interest in a direct PE investment or portfolio of direct PE investments to a new third-party investor. A secondaries fund is a PE fund raised by a fund-of-funds manager to acquire limited partnership interests in private equity from the original LPs. Secondary investing is no longer looked at as a source of liquidity for distressed investors, but as a differentiated investment strategy and a regular portfolio management tool to rebalance fund exposures and lock in realized gains. The secondary penetration rate (the percentage of total NAV across all PE strategies that trades in the secondary market) is still less than 2%13 but, as the secondary market continues to expand, investors may see a broader spectrum of assets on sale. Many investors look at the secondary market solely for opportunistic investments, making commitments only during or immediately following periods of market distress. Intuitively this makes sense, as secondary buyers should be able to negotiate steeper discounts during periods of elevated uncertainty and tight liquidity. However, there are many reasons to have a dedicated allocation: It Mitigates The J-Curve: Mature secondary investments cut off several years from the typical term of a PE fund because a good portion of the investment period is already completed. This generates immediate returns from the mature private-equity program. Many fund-of-funds managers will combine secondary interests with their primary portfolios to mitigate the J-curve. Less Blind Pool Risk: In private equity, LPs commit capital to a portfolio that is yet to be built. Secondary investing significantly reduces this risk because portfolios acquired are generally more than 50% invested and have less unfunded commitments. This provides investors with an actual portfolio of companies to evaluate. It Diversifies A Private-Equity Program: An allocation to secondaries can provide instant exposure to a highly diversified portfolio of mature private-equity interests. Lower Probability Of Poor Performance: The potential upside for secondary funds is not as high as that of primary funds, but the former produce poor returns much less frequently (Chart 20). Aditya Kurian, Senior Analyst Global Asset Allocation adityak@bcaresearch.com 1 Source: Bain Global Private Equity Report 2018. 2 Buyouts refers to deals in which a PE fund borrows a significant amount to acquire a target company or companies, which tend to be larger-cap private or publicly listed corporations. 3 Investments in mature companies with proven business models that are looking for capital to expand or restructure operations, enter new markets, or finance a major acquisition. 4 Apollo Investment Fund IX with an AUM of $24.7 billion raised in 2016-2017 is the largest buyout fund raised in history. 5 The amount of capital that has been committed to a private equity fund, but not yet deployed. 6 Source: Pitchbook. 7 The largest global buyout was the $17.9 billion carve-out of Toshiba Memory Corp in 2018. 8 Whereby a company owned by a private-equity fund issues debt in order to pay a dividend to the fund. 9https://www.cambridgeassociates.com/private-investment-benchmarks/ 10 To de-smooth returns, we used a first-order autoregressive model as shown by Rt = A0 + At Rt-1 + e, where At is the auto-regressive coefficient, and A0 is the intercept term. However, statistical methods do not always satisfactorily solve the problem of underestimated volatility for appraised asset values. 11 PME replicates the timing and size of private equity cash flows (purchases and sales) as if they had been invested in public equities. It is the dollar-weighted return that could have been achieved if funds had been invested in the index whenever a capital contribution was made and divested when the GP paid out a distribution. 12 In the Global Financial Crisis, Harvard Management Co issued a bond of more than $1 billion and considered selling a private equity stake of $1.5 billion at a 40%-50% discount to fund its capital calls. 13 Source: Preqin Ltd. Appendix: A Note On Data Sources And Definitions The performance indices all use quarterly unaudited, and annual audited fund financial statements produced by the GPs for their LPs. Partnership financial statements and narratives are the primary source of information concerning cash flows and ending residual/net asset values for both partnerships and portfolio company investments. The data providers' goal is to have a complete record of the quarterly cash flows and NAVs for all funds in the benchmark. All performance is calculated net of fees, expenses, and carried interest. Cambridge Associates (CA) uses two types of return calculation in its indices: Since Inception IRR: This calculates a discount rate which makes the NPV of an investment equal to zero. It is based on cash-on-cash returns over equal periods modified for the residual value of the partnership's equity or portfolio company's NAV. The residual value attributed to each respective group being measured is incorporated as its ending value. Transactions are accounted for on a quarterly basis, and annualized values are used for reporting purposes. End-To-End/Horizon IRR: A money-weighted return similar to the Since Inception IRR, except that it measures performance between two points in time. The calculation incorporates the beginning NAV, interim cash flows, and the ending NAV. All interim cash flows are recorded on the mid-period date of the quarter. With regards to avoiding survivorship bias, CA requires the complete set of financial statements from the fund's inception to the most current reporting date. When an active fund stops providing financial statements, CA reaches out to the manager to encourage them to continue to submit data. CA may, during this communication period, roll forward the fund's last reported quarter's NAV for several quarters. When CA is convinced that the manager will not resume reporting, the fund's entire performance history is removed from the database. Survivorship bias can affect all investment manager databases, including those of public asset managers. But the illiquid nature of private investments can actually help limit this impact, since the private investment partnerships owning illiquid assets will continue to exist and be legally required to report to the LPs even after the original manager ceases to exit. Over the past nine years the number of fund managers that stopped reporting to the database before liquidation averaged per year 0.7% of the total number of funds, and 0.6% of total NAV in the database. During that period the overall number of funds in the database increased by an average of 8% per year. Public Market Equivalent (PME): A private-to-public comparison that seeks to replicate private-investment performance under public-market conditions. The public index is recalculated as if shares were purchased and sold according to the private fund's cash flow schedule, with distributions calculated in the same proportion as the private fund. The PME NAV is a function of PME cash flows and public index returns. The PME attempts to evaluate the return that would have been earned had the dollars been deployed in the public markets instead of in private investments.

Special Report

Highlights The Global Golden Rule (GGR): The gap between market expectations of global central bank policy rates and realized interest rate outcomes is a reliable predictor of government bond returns. Thus, "getting the policymaker call right" is the key to outperformance for bond investors. Implied Government Bond Yields: Given the strong correlation between policy rate surprises and government bond yield changes, we can use the GGR to forecast yields one year from now based on our own assumptions of how many rate hikes (cuts) will be delivered versus what is discounted in money market yield curves. Total Return Forecasts: We can use implied government bond yield changes from the GGR to generate expected 12-month total returns for government bond indexes of different maturities, taking into account different rate hike assumptions for various central banks. Feature Chart 1Global Monetary Divergences? This month marked the ten-year anniversary of the 2008 Lehman Brothers default, which set off a worldwide financial crisis and a massive easing of global monetary policy. Extraordinary measures - zero (or negative) interest rates, large-scale asset purchases and dovish forward guidance from policymakers - were all successful in suppressing both global bond yields and volatility over time, helping the global economy slowly heal from the crisis. Now, a decade later, such hyper-easy monetary policies are no longer required given low unemployment rates and rising inflation in the major developed economies. That can be seen today with the Federal Reserve shifting to "quantitative tightening" (letting bonds run off its swollen balance sheet) alongside steady rate hikes, the European Central Bank (ECB) set to stop net new buying of euro area bonds at year-end, and the Bank of Japan (BoJ) dramatically slowing its pace of asset purchases. BCA's Central Bank Monitors, which assess the cyclical pressure on policymakers to tighten or ease monetary policy, have collectively been calling for interest rate increases since the start of 2017. Yet our Central Bank Monetary Barometer, which measures the percentage of central banks that have tightened policy over the previous three months, shows that only 1 in 5 banks have actually delivered rate hikes of late (Chart 1). Thus, the risks are tilted towards more countries moving away from highly accommodative monetary conditions given tightening labor markets and rising inflation pressures. This now-global shift towards policy normalization has major implications for global bond investing. The focus is now returning back to more traditional drivers of government bond returns, like changes in central bank policy rates. We recently shared a Special Report published by our colleagues at our sister BCA service, U.S. Bond Strategy, describing a methodology they dubbed "The Golden Rule of Bond Investing".1 That report introduced a numerical framework that translates actual changes in the U.S. fed funds rate relative to market expectations into return forecasts for U.S. Treasuries. The historical results convincingly showed that investors who "get the Fed right" by making correct bets on changes in the funds rate versus expectations were very likely to make the right call on the direction of Treasury yields. In this Special Report, we extend that Golden Rule analysis to government bonds in the other major developed markets (DM). Our conclusion is that utilizing a "Global Golden Rule" (GGR) framework that links bond returns to unexpected changes in policy rates can help bond investors correctly forecast changes in non-U.S. bond yields. The report is set up in two sections. First, we illustrate how the GGR works and how it empirically tends to generally succeed over time for different DM bond markets. In the second section, we make use of the GGR to generate expected return forecasts for non-U.S. government bonds for a variety of interest rate "surprise" scenarios. ECB Policy Rate Surprises Dovish surprises from the ECB do reliably coincide with positive German government bond excess returns versus cash (Chart 2A). Chart 2AECB Policy Rate Surprise & Yields I Chart 2BECB Policy Rate Surprise & Yields II The 12-month ECB policy rate surprise and the 12-month change in the Bloomberg Barclays German Treasury index yield displays a strong positive correlation (Chart 2B). The excess returns during periods of dovish surprises is 14.4% on average and are positive 85% of the time. Hawkish surprises on the other hand, coincide with negative average excess returns of -1.5% (Chart 2C). In terms of total return, the picture is roughly the same except that under hawkish surprises, the average total return you would expect is now positive, given that it factors in coupon income (Chart 2D). Chart 2CGermany: Government Bond Index Excess Return & ECB Policy Rate Surprises (2004 - Present) Chart 2DGermany: Government Bond Index Total Return & ECB Policy Rate Surprises (2004 - Present) Table 1Germany: 12-Month Government Bond Index Returns And Rate Surprises (2004 - Present) Looking ahead, the ECB should not deviate from its current dovish forward guidance of no interest rate hikes until at least the third quarter of 2019. That is somewhat consistent with the reading of the ECB monitor being almost equal to zero. Bank Of England (BoE) Policy Rate Surprises The GGR works well for the U.K. as can be seen in Chart 3A. Chart 3ABoE Policy Rate Surprise & Yields I Chart 3BBoE Policy Rate Surprise & Yields II The 12-month BoE policy rate surprise and the 12-month change in the Bloomberg Barclays U.K. Treasury index yield displays a strong positive correlation except for a major divergence in 1997-1998 (Chart 3B). Dovish surprises coincide with positive excess returns over cash 78% of the time and are on average equal to 6.2% over the full sample (Chart 3C and Chart 3D). As you would expect if the GGR applies, hawkish surprises coincide with negative excess returns. Chart 3CU.K.: Government Bond Index Excess Return & BoE Policy Rate Surprises (1993 - Present) Chart 3DU.K.: Government Bond Index Total Return & BoE Policy Rate Surprises (1993 - Present) Table 2U.K.: 12-Month Government Bond Index Returns And Rate Surprises (1993 - Present) Looking ahead, outcomes will be biased toward dovish surprises over the next six months given the uncertain outcome of the U.K.-E.U. Brexit negotiations. Against that backdrop, the BoE will remain accommodative despite inflationary pressures building up. Bank Of Japan (BoJ) Policy Rate Surprises The GGR does not seem to work when it comes to the Japanese bond market. This reflects the fact that both the markets and the Bank of Japan (BoJ) have understood that chronic low inflation has required no changes in BoJ policy rates (Chart 4A, second panel). Chart 4ABoJ Policy Rate Surprise & Yields I Chart 4BBoJ Policy Rate Surprise & Yields II While the 12-month BoJ policy rate surprise and the 12-month change in the Bloomberg Barclays Japan Treasury index yield displayed a strong positive correlation pre-1998, the correlation has broken down since then (Chart 4B). Negative excess returns over cash both coincide with dovish and hawkish surprises, on average over time. Further, dovish surprises coincide with positive excess returns only 45% of the time (Chart 4C and Chart 4D). Chart 4CJapan: Government Bond Index Excess Return & BoJ Policy Rate Surprises (1994 - Present) Chart 4DJapan: Government Bond Index Total Return & BoJ Policy Rate Surprises (1994 - Present) Table 3Japan: 12-Month Government Bond Index Returns And Rate Surprises (1994 - Present) Looking ahead, given that the BoJ will in all likelihood maintain its ultra-accommodative monetary policy stance in the near future, we do not expect the GGR to become more effective when applied to the Japanese bond market. Bank Of Canada (BoC) Policy Rate Surprises The GGR works relatively well for the Canadian bond market (Chart 5A). Chart 5ABoC Policy Rate Surprise & Yields I Chart 5BBoC Policy Rate Surprise & Yields II We observe a tight correlation between 12-month BoC policy rate surprises and the 12-month change in the Bloomberg Barclays Canada Treasury index yield, especially post-2010 (Chart 5B). Dovish surprises coincide with positive excess returns 81% of the time and 94% of the time if we look at total returns (Chart 5C and Chart 5D). Chart 5CCanada: Government Bond Index Excess Return & BoC Policy Rate Surprises (1993 - Present) Chart 5DCanada: Government Bond Index Total Return & BoC Policy Rate Surprises (1993 - Present) Table 4Canada: 12-Month Government Bond Index Returns And Rate Surprises (1993 - Present) Looking ahead, the BoC will most likely continue to follow the tightening path of the Federal Reserve, admittedly with a lag. However, accelerating inflation at a time when there is no spare capacity in the Canadian economy suggests that the BoC could deliver more rate hikes than are already priced for the next 12 months. As shown in Table 4, hawkish surprises from the BoC do coincide with negative monthly excess returns of -2.8%. Reserve Bank Of Australia (RBA) Policy Rate Surprises The GGR applies extremely well to the Australian bond market (Chart 6A). Chart 6ARBA Policy Rate Surprise & Yields I Chart 6BRBA Policy Rate Surprise & Yields II The 12-month RBA policy rate surprise and the 12-month change in the Bloomberg Barclays Australia Treasury index yield displays the tightest correlation out of all the countries covered (Chart 6B). Dovish surprises coincide with positive excess returns 83% of the time and 96% of the time if we look at total returns (Chart 6C and Chart 6D). Turning to hawkish surprises, they reliably coincide with negative excess returns. Chart 6CAustralia: Government Bond Index Excess Return & RBA Policy Rate Surprises (1994 - Present) Chart 6DAustralia: Government Bond Index Total Return & RBA Policy Rate Surprises (1994 - Present) Table 5Australia: 12-Month Government Bond Index Returns And Rate Surprises (1994 - Present) As can be seen on the bottom panel of Chart 6A, the RBA Monitor has been rapidly falling since 2016 and now stands in the "easier monetary policy" required. However, the RBA will likely have to see a rise in unemployment or a decline in realized inflation before it considers cutting rates, which raises a risk of "hawkish" surprises if the market begins to price in rate cuts. Reserve Bank Of New Zealand (RBNZ) Policy Rate Surprises The GGR works fairly well for Nez Zealand (NZ) government bonds (Chart 7A). Chart 7ARBNZ Policy Rate Surprise & Yields I Chart 7BRBNZ Policy Rate Surprise & Yields II 12-month RBNZ policy rate surprises and the 12-month change in the Bloomberg Barclays NZ Treasury yield exhibit a decent correlation (Chart 7B). Unusually, NZ is the only bond market covered in this report where both dovish and hawkish surprises coincide with positive excess returns on average, although positive episodes are much less frequent for hawkish surprises than for dovish surprises; respectively 55% and 86% (Chart 7C and Chart 7D). Chart 7CNZ: Government Bond Index Excess Return & RBNZ Policy Rate Surprises (2000 - Present) Chart 7DNZ: Government Bond Index Total Return & RBNZ Policy Rate Surprises (2000 - Present) Table 6New Zealand: 12-Month Government Bond Index Returns And Rate Surprises (2000 - Present) Looking ahead, the RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will most likely stay flat until 2020 - an assessment that we agree with, so the odds are against any policy surprises over at least the next 6-12 months. Using The Global Golden Rule To Forecast Government Bond Returns The practical application of the GGR is that it can be used as a framework for generating expected changes in yields and calculating total return forecasts for global government bond indices. The strong correlation demonstrated in the previous section between the 12-month policy rate surprises and the 12-month change in the average yield from the government bond indexes allows us to translate our "assumed" policy rate surprise over the next 12 months into expected changes in yields along the curve. With these expected yield changes, we can simply generate expected total returns using the following formula: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(DY2) E(DY2) = 1-year trailing estimate of yield volatility It is important to note that we would not give too much importance to what this analysis yields for longer-dated bonds. As shown in the Appendices, once we move into longer government bond maturities, the correlation between the policy rate surprise and the change in yields declines or even becomes non-existent for some countries. This result should not be surprising, as longer-term yields are driven by other factors besides simply changes in interest rate expectations. Inflation expectations, government debt levels and demand from longer-term investors like pension funds all can have a more outsized influence on the path of longer-term bond yields relative to the shorter-end. That results in much more uncertainty when it comes to the total return forecasts for long-dated maturities calculated with this framework. Practically speaking, we are not encouraging our readers to blindly follow that yield and return expectations generated by the GGR, even for bond markets where it clearly seems to be working over time. Rather, the GGR can be integrated in a larger asset-allocation framework for a global fixed-income portfolio by providing one possible set of bond market outcomes. On a total return basis, the results presented below, interpreted alongside the readings on the BCA Central Bank monitors, suggest that investors should be underweight core Euro Area (Germany, France and Italy), Australia and New Zealand while remaining overweight the U.K. and Canada over the next twelve months. As for Japan, given the likelihood that BoJ will leave its policy rate flat, the results hint at a neutral allocation. Jeremie Peloso, Research Analyst jeremie@bcaresearch.com Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com. 2 Please see Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: Divergences Opening Up," dated September 19, 2018, available at gfis.bcaresearch.com. Global Golden Rule: Germany In light of the forward guidance ECB President Mario Draghi has been providing to the markets, it appears that the most likely scenario over the next 12 months is for the ECB to keep interest rates on hold. Based on the strong relationships between 12-month ECB policy rate surprises and 12-month changes in yields along the curve (Appendix A), a flat interest rate scenario would be bond bearish for German government bonds especially at the short end of the curve with the 1-year German yield expected to rise by 16bps (Table 7A). Table 7AGermany: Expected Changes In Bund Yields Over The Next 12 Months (BPs) Using the expected change in yields thus inferred by the policy rate surprise, the German government bond aggregate index is forecasted to return 0.45% over the next 12 months (Table 7B). Table 7BGermany: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: U.K. Markets are currently discounting only 21bps of rate hikes in the U.K. over the next year. Thus, even a scenario where the BoE delivers only a single 25bp rate hike would be bearish for U.K. Gilts, especially at the short-end of the curve. Applying the GGR, 1- and 3-year Gilt yields would be expected to rise by 20bps and 10bps respectively (Table 8A). Table 8AU.K.: Expected Changes In Gilt Yields Over The Next 12 Months (BPs) Interpolating these expected yield changes, the 1-3 year government bond index total return forecast would be 0.46%. On the other hand, if the BoE prefers to keep rates on hold given the uncertainty of the Brexit outcome, that same 1-3 year government bond index is forecasted to deliver 0.97% of total return over the next 12 months (Table 9B). This is our current base case scenario for Gilts. Table 8BU.K.: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Japan Despite many rumors to the contrary earlier this year, the base case view remains that the BoJ will not change its stance on monetary policy anytime soon. As such, the expected changes in JGB yields under a flat interest rate scenario over the next 12 months are close to zero at the short end of the curve and rather bond bullish at the longer end of the curve; for instance, the 30-year JGB yield would be expected to rally by 9bps (Table 9A). Table 9AJapan: Expected Changes In JGB Yields Over The Next 12 Months (BPs) In that most likely scenario, the Japanese government bond index is forecasted to deliver 0.83% of total return over the next 12 months. In the event that the BoJ surprises the markets by delivering one rate hike of 25bps, it would be bond bearish for JGBs and the total return forecasts for the government bond indices would be negative, regardless of the maturity (Table 9B). Table 9BJapan: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Canada Will the Bank of Canada follow the footsteps of the Fed? The markets certainly seem to think so, with more than three 25bps rate hikes priced in for next 12 months in the OIS curve. Table 10ACanada: Expected Changes In Government Bond Yields Over The Next 12 Months (BPs) That scenario would be outright bearish for Canadian government bonds, with 1- and 2-year yields rising by 16bps and 21bps, respectively (Table 10A). In terms of total returns, the GGR framework forecasts that with 75bps of rate hikes, the Canadian government bond aggregate index would deliver a positive return of 2.35% (Table 10B). This is because 75bps of hikes are currently discounted in the Canadian OIS curve, thus it would neither be a hawkish nor dovish surprise. Table 10BCanada: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Australia The RBA Monitor just dipped below the zero line, implying that easier monetary policy is required based on financial and economic data. Table 11A shows that a rate cut delivered by the RBA in the next 12 months would be bond bullish for Aussie yields, especially at the long end of the curve, where the 30-year Aussie bond yield would fall by 34bps. Table 11AAustralia: Expected Changes In Aussie Yields Over The Next 12 Months (BPs) Of all the interest rate scenarios presented in Table 11B, the two rate cut scenarios would return the highest total returns. For instance, the Australian government bond aggregate index would return 2.80% and 3.90% in the event of one and two 25bps rate hikes, respectively. Table 11BAustralia: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: New Zealand Our view is that the Reserve Bank of New Zealand will stay on hold for a while longer, which is broadly the same message conveyed by the RBNZ Monitor being positive, but very close to 0. With that in mind, a flat interest rate scenario appears to be bond bearish for the NZ bond yields, except for the longer end of the curve (Table 12A). Table 12ANew Zealand: Expected Changes In NZ Yields Over The Next 12 Months (BPs) Table 12BNew Zealand: Government Bond Index Total For New Zealand, the government bond aggregate bond index is the only index provided by Bloomberg Barclays, as opposed to the other countries in our analysis where different maturities are given. In the flat interest rate scenario, the total return forecast for the overall index would be of 2.53% over the next 12 months. Appendix A: Germany Chart 1Change In 1-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 2Change In 2-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 3Change In 3-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 4Change In 5-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 5Change In 7-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 6Change In 10-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 7Change In 30-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix B: France Chart 8Change In 1-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 9Change In 2-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 10Change In 3-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 11Change In 5-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 12Change In 7-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 13Change In 10-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 14Change In 30-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix C: Italy Chart 15Change In 1-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 16Change In 2-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 17Change In 3-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 18Change In 5-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 19Change In 7-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 20Change In 10-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 21Change In 30-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix D: U.K. Chart 22Change In 1-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 23Change In 2-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 24Change In 3-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 25Change In 5-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 26Change In 7-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 27Change In 10-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 28Change In 30-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Appendix E: Japan Chart 29Change In 1-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 30Change In 2-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 31Change In 3-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 32Change In 5-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 33Change In 7-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 34Change In 10-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 35Change In 30-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Appendix F: Canada Chart 36Change In 1-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 37Change In 2-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 38Change In 3-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 39Change In 5-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 40Change In 7-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 41Change In 10-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 42Change In 30-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Appendix G: Australia Chart 43Change In 1-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 44Change In 2-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 45Change In 3-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 46Change In 5-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 47Change In 7-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 48Change In 10-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Appendix H: New Zealand Chart 49Change In 1-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 50Change In 2-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 51Change In 3-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 52Change In 5-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 53Change In 7-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 54Change In 10-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise

Highlights Portfolio Strategy The firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable new home sales expectations, all signal that it is time to buy homebuilders. On the flip side, we do not want to overstay our welcome in the S&P home improvement retail index as a number of leading industry profit indicators have started to wave a yellow flag. Recent Changes Boost the S&P Homebuilding index to overweight today. Trim the S&P Home Improvement Retail index to neutral and lock in gains of 13.3% today. Table 1 Feature Another week, another SPX all-time high. Investors have refocused their attention on the important macro drivers: solid profits, easing fiscal policy, and still-benign monetary policy with the real fed funds rate barely probing 0%. Trade-related rhetoric has taken the back seat as it has now become obvious that the rest of the world will bear the brunt of President Trump's trade escalation. Our EPS growth models are sniffing this out, with the SPX ticking higher, while our global profit model sinking close to nil (Chart 1). Chart 1Ex-U.S. EPS Will Bear The Brunt Of Trade Wars Importantly, we are impressed by how thick-skinned the market has become to negative trade-related news. Putting the looming Chinese tariffs into proper perspective is instructive. Assuming a 25% tariff rate on $250bn worth of Chinese manufactured goods and no relief from the renminbi's steep depreciation since April, results in a "tax" of $63bn. The net new "tax" is actually $53bn as an average 3.8%1 import tariff rate already exists on manufactured goods. The consumer and corporations will bear the brunt of this "tax", so it is worth examining the data on household net worth, consumer incomes, and corporate sales. Federal Reserve data show that household net worth increased by $8.1tn in the past year. BEA data reveal that total wage & salary disbursements increased by $400bn, and BCA's projections call for $600bn increase in SPX sales for 2019 (using IBES data for calendar 2019, Chart 2). In other words, it becomes clear that $53bn in a new tariff "tax" will barely eat into net worth, consumer incomes or corporate revenue flows. In addition, according to the IMF, fiscal easing in 2019 will surpass even this year's fiscal expansion in the U.S. The upshot is that over 1% of GDP in fiscal thrust in 2019 thwarts the specter of tariffs, before the fiscal impulse turns negative starting in 2020 (bottom panel, Chart 2). Meanwhile, following up from last week's report when we posited that the current macro backdrop resembles more the mid-2000s than the late-1990s, we are challenging ourselves and asking what if we are wrong in our assessment. Could we actually be replaying a late-1990s episode instead? Revisiting the late-1990s in more detail is in order, refreshing our memory on the sequence of events that led to the climactic LTCM bailout, and highlighting potential signposts that can be helpful in navigating today's macro and equity market maps. In March 1997 the Fed raised rates and pushed the fed funds rate to 5.5%. In hindsight that was a mistake as the Fed then paused the tightening cycle and watched as the Thai baht began to tumble in late-June 1997, eventually gripping all of the emerging world. True, the U.S. stock market modestly pulled back in October 1997 and the VIX spiked to 38. Then, as equities recovered in Q1/1998 and jumped to fresh all-time highs, suddenly the yield curve inverted in May 1998. Undeterred, the S&P 500 hit another peak in July of 1998 before falling roughly 20% in the subsequent month. Finally, once Russia defaulted and the Fed had to bail out the banks due to the LTCM fiasco, the FOMC, late in the game in September 1998, started to ease monetary policy, and engineered a steepening of the yield curve (Chart 3). Chart 2Trade "Tax" A Drop In The Bucket Chart 3Sequence Of Macro Events Matters The most important signpost from this trip down memory lane is the yield curve. In other words, heed the signal from the bond market: the yield curve inversion correctly predicted a reversal of Fed policy and naturally led the temporary peak in the stock market. Importantly, despite the peak-to-trough near-20% decline in the SPX between July and late-August 1998, if someone had bought the index on Jan 2, 1998 and held through the cathartic LTCM bailout, they remained in the black (bottom panel, Chart 3), and a buy the dip strategy was a winning one. As a last reminder, the SPX jumped another 65% from the August 1998 trough until the March 2000 peak that was preceded, once again, by another yield curve inversion. At the current juncture, were the yield curve to invert we would become overly cautious on the broad equity market as we highlighted in late-June2, and would begin to transition the portfolio away from cyclicals and toward defensives. But, we are not there yet. Thus, we sustain our sanguine broad equity market outlook on a 9-12 month horizon and our SPX target remains 10% higher with EPS doing all the heavy lifting as the multiple moves sideways (for more details, please refer to our April 30th, 2018 Weekly Report titled "Lifting SPX Target"). This week we are taking a deeper dive in housing and housing-related equities and making a subsurface portfolio shift. Look Through The Housing Soft Patch, And... While housing-related data releases have been slightly weaker than anticipated lately, we deem that this softness is transitory as housing market fundamentals rest on solid foundations. On the demand side, first-time home buyers still make only a third of total home sales and the homeownership rate is near generational lows, underscoring that pent up housing demand exists. In fact, the percentage of 18-34 year-olds that live with their parents remains close to 32% a multi-decade high and also represents another source of housing demand that has been dormant because of the Great Recession (Chart 4). Importantly, household formation is still running at a higher clip than housing starts and permits, signaling that the risk of a significant supply/demand imbalance is rising. Historically, this gets resolved via higher prices. Further on the supply side, inventories of existing and new homes for sale remain low and point toward a tight residential housing market (Chart 5). The 98.5% homeowner occupancy rate corroborates the apparent residential real estate market tightness. Chart 4Homeownership Still Well Within Reach Chart 5Positive Housing Demand/Supply Dynamics True, affordability has taken a hit both as a result of rising home price inflation and mortgage rates. But, putting affordability in historical context reveals that homeownership is still well within reach. Were we to exclude that aberration of the post 2007 surge in affordability owing to the collapse in house prices and all-time lows in mortgage rates, affordability is higher than the 1992-2007 range and only lower than the early 1970s. The reason is largely because of still generationally-low interest rates (Chart 5). While a rising interest rate backdrop and sustained house price inflation will continue to dent affordability, as long as job certainty remains intact and wage growth picks up steam as we expect (please see Chart 4 from last week's publication), we doubt that the U.S. housing market will suffer a relapse. ...Boost Homebuilders To Overweight, But... In that light, we recommend augmenting exposure to overweight in the S&P homebuilding index. With the labor market at full employment and unemployment insurance claims on the verge of breaking below the 200K mark, housing starts should regain their footing (Chart 6) and propel homebuilding profits. In addition, the latest Fed Senior Loan Officer survey showed that demand for residential real estate loans ticked higher, while simultaneously bankers remain willing extenders of mortgage credit. The implication is that new home sales will likely reaccelerate in the coming months (third & bottom panels, Chart 7). Chart 6Homebuilders Rest On Solid Foundations Chart 7Lumber Input Cost Relief While galloping lumber prices were previously a key reason for putting the S&P homebuilding index on our high-conviction underweight list, the recent liquidation, down $300/thousand board feet since the mid-May peak, in lumber prices represents a massive input cost relief for homebuilders (second panel, Chart 7). With regard to the relative pricing power front, previous price concessions (new home prices compared with existing home prices) are paying off as new home sales are steadily gaining a larger slice of the overall home sales pie (second & third panels, Chart 8). As input cost relief is slated to kick in during the next few months, especially on the framing lumber front, at a time when new home prices have stabilized, homebuilding sales and profits will likely overwhelm (bottom panel, Chart 8). While the latest NAHB/Wells Fargo National Home Market survey showed some softness on the overall housing market index (HMI), keep in mind that both the HMI and the sales expectations subcomponents of the survey are squarely above the 50 boom/bust line and only slightly below the recent cyclical highs (top and second panels, Chart 9). This healthy housing backdrop is also evident in plentiful construction job openings and expanding national house prices (third & bottom panels, Chart 9). Nevertheless, there are two risks to our upbeat S&P homebuilding view. First, interest rates. At the margin, rising mortgage rates can be a source of deficient housing demand especially for first-time home buyers. However, as mentioned earlier, interest rates are generationally low (middle panel, Chart 10) and the job market remains vibrant which should continue to entice first-time home buyers to make one of the largest purchase decisions of their lifetime. Chart 8Price Hikes Should Stick Chart 9Big Gaps Set To Narrow Chart 10Two Risks: Interest Rates & Wages Second, industry wage inflation. Construction sector wages are climbing rapidly, as much as 150bps faster than overall average hourly earnings (bottom panel, Chart 10). This is another key input cost for homebuilders that could eat into profit margins, especially if new home price inflation does not stick. In sum, a firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable leading indicators of new home sales will more than offset rising interest rates and industry wage inflation. Bottom Line: A playable opportunity has surfaced to ride the S&P homebuilding index higher. Lift exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. ...Don't Over Stay Your Welcome In Home Improvement Retailers Nevertheless, we do not want to overstay our welcome on the other residential real estate-levered consumer discretionary subgroup, the S&P home improvement retail (HIR) index. We recommend a downgrade to a benchmark allocation for a relative gain of 13.3% since the July 5, 2016 inception. Such a move does not reflect a worsening overall housing view; as we made clear in our analysis above, we remain housing market bulls. Instead, we are concerned that too much euphoria is already priced in HIR equities. Chart 11 shows that fixed residential investment as a percentage of GDP is up 50% from trough to the recent peak (similar to the advance in existing home sales), whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass (bottom panel, Chart 11). Three main reasons are behind our softening EPS backdrop for home improvement retailers. First, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 12). Lumber deflation in particular will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Chart 11Too Much Euphoria Chart 12Timberrrr! Second, household appliance and furniture & durable selling prices have tentatively crested, and represent another source of profit headaches for HIR (bottom panel, Chart 13). Finally, select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone (second & third panels, Chart 13). But there are still some pockets of strength in the home improvement retailing industry that prevent us from turning outright bearish on the S&P HIR index. Despite the aforementioned easing in appliance and furniture wholesale prices, our HIR implicit price deflator has spiked on a short-term rate of change basis, likely owing to firm demand for remodeling activity. Indeed, the latest NAHB remodeling survey remains perched near record highs. The implication is that the recent lull in industry sales growth may reverse (middle and bottom panels, Chart 14). Importantly, a large driver of the previous cycle's remodeling activity was the availability of HELOCs and the stratospheric rise in Mortgage Equity Withdrawal (popularized by Fed economist Dr. James Kennedy). Now that home equity has nearly doubled to near 60% from the depths of the GFC, there are rising odds that homeowners may begin to tap their rebuilt equity and embark upon more renovations (top & middle panels, Chart 15). Tack on rising disposable incomes (bottom panel, Chart 15) and a buoyant labor market and the outlook for remodeling activity brightens further. Chart 13Operational Trouble Brewing... Chart 14...But Offsets... Chart 15...Exist Netting it out, is it prudent to lock in gains in the S&P HIR index as profit drivers have downshifted at the margin. Bottom Line: Crystalize gains of 13.3% in the S&P HIR index since inception, and downgrade exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Source: The World Bank, https://data.worldbank.org/indicator/TM.TAX.MANF.SM.FN.ZS?locations=US&name_desc=true 2 Please see BCA U.S. Equity Strategy Weekly Report, "Has The Reward/Risk Tradeoff Changed?" dated June 25, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights Rates are going higher ... : Flight-to-quality episodes aside, the bond bear market that began in July 2016 remains in force. Investors should maintain below-benchmark Treasury duration. ... but that doesn't necessarily spell immediate trouble for stocks: Consistent with our work on the fed funds rate cycle, it appears that the level of rates matters more for equity returns than their direction. Empirical evidence of a rates tipping point is elusive ... : The notion that investors migrate from stocks to bonds at a particular level of rates exerts a powerful intuitive appeal, but the data fail to validate it. ... but a 10-year yield Treasury of 3.75 - 4% might halt the bull market in its tracks: Higher rates reliably slow equities only when they rise enough to slow the economy. We estimate that the pinch point is somewhere in the neighborhood of a 3.75 - 4% 10-year Treasury yield. Feature A share of stock is a pro rata claim on the future earnings of the company that issued it. Holding future earnings constant, the price an investor will be willing to pay for a share is wholly a function of the rate used to discount its earnings back to the present day. The simplicity and ubiquity of this valuation approach suggest that equity returns should be predictably related to moves in interest rates. It may also point the way to a tipping point - either in the level of rates, or the magnitude of their rise - at which capital and savings migrate from stocks to bonds. This Special Report reviews the historical record to see how U.S. equities have interacted with real 10-year Treasury yields. It considers the key variables that would logically seem to bear on equity performance and investors' propensity to rotate between asset classes. We find that the relationship between rates and equity returns is conditional, depending on which crosscurrent dominates in any given episode. We did not uncover any predictable rotation pattern. Do The Math As noted above, valuing a stream of future cash flows is a simple mechanical process once one settles on an appropriate discount rate for converting future dollars to current dollars. According to the security analysis textbooks, then, moves in stock prices are inversely related to changes in interest rates. But the textbooks leave out one key point: changes in interest rates don't occur in a vacuum. When they change, earnings estimates are likely to change, too, most often in the same direction as real rates. To be sure, the denominator discounting future cash flows rises when real rates rise, but the future-earnings numerator most likely rises, too. If real rates are rising, the economy is probably gaining momentum, and earnings estimates should probably be revised higher as well. Conversely, falling rates lead to a higher earnings multiple (ex-the not insignificant animal-spirits wild card), but will regularly be accompanied by downward revisions in future earnings. The net effect is uncertain, and depends on whether the multiple change outweighs the change in earnings or vice versa. Bonds Are A Snap Compared To Stocks It's far simpler to compute the impact on a bond portfolio from a given increase in interest rates because the denominator is the only variable that changes. The future-cash-flows numerator is contractually fixed, and it takes a big shift in the state of the economy to spark an economy-wide change in perceived repayment potential.1 This is why bonds' sensitivity to changes in interest rates can be captured in a single universal metric (duration). Stocks are pulled in so many different directions by factors affecting future cash flows that duration has no equity analogue. Investors should therefore be cautious about pinning too much on interest rates as they relate to equities. Bonds move in fixed orbits around the interest-rate sun, according to strictly ordered rules that establish a very clear cause-and-effect relationship. Equities improvise as they go along, taking their cues from a rotating cast of variables that interact differently over time. Attempts to stretch the concept of interest-rate sensitivity beyond bonds regularly trip up equity investors; we cannot know in advance how rates will come together with the other factors that influence equities. Confounding Intuition, Part 1: Equities Prefer Rising Rates (And Multiples Don't Care) U.S. postwar history makes it clear that equity investors need not run from rising rates. The S&P 500 has fared considerably better when real 10-year yields have risen by at least 100 basis points ("bps") than it has when they've declined by that magnitude (Chart 1), gaining 9.4% and 5%, respectively (Chart 2). Rates do not exhibit any sort of a consistent relationship with either forward (Chart 3) or trailing (Chart 4) S&P 500 multiples, though extremely high and extremely low real yields are both associated with lower trailing P/Es. Negative real yields carry an unwelcome whiff of deflation, and their scatterplot data points tend to cluster at below-the-mean forward and trailing multiples. Chart 1Stocks Actually Do Better When Rates Rise ... Chart 2... Considerably Better When Do Higher Rates Hurt The Economy? Charts 3 and 4 show that both forward and trailing multiples almost always decline when real 10-year Treasury yields cross above 5%. What's bad for multiples isn't necessarily bad for earnings, however, and a 5% real threshold is irrelevant to today's cycle. The steady decline in the average fed funds rate over the last several completed cycles (Chart 5) makes it clear that neutral rate thresholds are not constant across time periods. Assessing interest rates' impact on the economy over time requires a sliding scale. Chart 3Hard To See A Trend Through The Windshield ... Chart 4... Or The Rear-View Mirror Estimates of potential economic growth provide a useful yardstick for measuring the impact of real yields. Comparing real long rates to potential output offers insight into the burden of servicing debt across the economy. If real rates exceed the economy's potential growth rate by a material amount, several marginal borrowers are likely to be gasping for air, and their travails will weigh on the economy. Conversely, servicing debt should be easy when real rates are below potential growth, and investors are more likely to invest, businesses are more likely to expand, and consumers are more likely to spend. Chart 5One Size Does Not Fit All There have been 22 instances in the postwar era when real 10-year Treasury yields have increased by at least 100 bps, and Table 1 lists all of them, grouped by their relationship to real GDP's potential five-year growth rate. There are three possible states for interest rate increases in relation to potential output: starting and ending below trend growth, starting below trend growth and ending above it, and starting and ending above trend. The S&P 500 comfortably tops its overall postwar returns when rates go from Below-to-Below and Below-to-Above, but declines outright when rates start above potential growth and go even higher. Earnings consistently rise when rates start below potential growth, making multiples the swing factor - when they expand, S&P 500 gains tend to be very large (Box 1). Table 1Real Rates Versus Potential GDP Growth Box 1 Decomposing S&P 500 Returns Table 2 details the decomposition of S&P 500 returns during rising real rate episodes occurring after S&P 500 earnings estimates began to be compiled in 1979. Except in the crucible of 2009, when they were flat, forward earnings estimates have always risen when rates rise from a below-trend starting point, putting a tailwind behind the S&P 500 that regularly overcomes the multiple contraction that occurs in half of the Below/Above instances. Multiples are the swing factor; when they expand in conjunction with rising earnings estimates, U.S. equities soar. They always contract when rates go from high to higher, dragging stocks down against a mixed earnings expectations backdrop. The action is consistent with our fed funds rate cycle work: stocks do best when rates are below equilibrium and falling because earnings and multiples expand in tandem in that setting, but they do nearly as well after rate hikes commence, in spite of multiple contraction. Earnings surge when the Fed is confident enough about the economy to embark on a tightening cycle, but has not yet hiked enough to choke off the expansion. Multiple expansion in a majority of the Below/Above instances reveals that investors do not rotate out of equities en masse when rates rise, even by a considerable amount. The rotation story has intuitive appeal, but it doesn't show up in these data. Table 2Decomposition Of S&P 500 Returns During Rising Rate Periods A Little More Slicing And Dicing (Potential GDP Matters) Chart 6Mind The Gap Defining Below-to-Below and Below-to-Above states is easy in hindsight, but an investor cannot know in real time where a rising-rate instance that begins with rates below potential output will end. Earnings rise no matter where rates end relative to potential GDP, but re-rating in Below/Below can flip to de-rating in Below/Above, slamming the brakes on phase gains. The empirical data say investors should lighten up on S&P 500 exposure when real rates cross above real potential GDP. S&P 500 returns trounce their overall postwar gain when rates rise from below potential GDP to potential GDP but lag it once rates cross above potential GDP (Chart 6). Confounding Intuition, Part 2: Institutional Investors Don't Rotate Even if S&P 500 returns fail to demonstrate any consistent relationship with interest rates, one would expect that professional investors' asset-class positioning would. Bonds and stocks are alternatives for one another, and institutional investors presumably shift their allocations in line with the asset classes' relative prospects. We examine Pension Funds', Life Insurers', and Mutual Funds' asset-allocation profiles over time using balance-sheet data from the Federal Reserve's quarterly Flow of Funds report. The data show that asset-allocation decisions are made without apparent regard for relative valuations, at least as proxied by the equity risk premium. Pension funds' steady increase in equity allocations across the '90s appears to have been less a function of rate moves than buying into the bull market (Chart 7). Since the dot-com bubble burst in 2000, bond and equity allocations have mainly reflected the performance tides. The extended trend in pension funds' equity-to-bond allocation ratio suggests that the funds set a long-range goal and grind steadily toward achieving it, regardless of relative valuation movements. It also suggests that the funds may not bother with rebalancing, much less dynamic asset allocation. Life insurers kept their fixed income and equity allocations more or less fixed across the '70s (not shown) and most of the '80s. They then reduced equity exposure for three years after 1987's Black Monday, assiduously built it up across the '90s, and have more or less let it drift since the millennium (Chart 8). The equity risk premium does not appear to have been a consideration. Asset-allocation stasis may simply be a reflection of life insurers' stringent regulatory constraints, but their portfolio managers' limited discretion precludes opportunistic allocation shifts. Mutual fund allocations tend to depend much more on past events than future expectations. Equity holdings peak when the equity risk premium bottoms and bottom when the equity risk premium peaks (Chart 9). The problem is that mutual fund managers are structurally hostage to their investors' whims. They are sorted into narrow silos and then straitjacketed by the rigid allocation rules written into their fund prospectuses. Even if they think asset-class rotation is a great idea, only a tiny minority of fund managers can act upon it. Chart 7Pension Funds Don't Allocate Based On Yields Or The ERP ... Chart 8... While Life Insurers Appear To Allocate In Defiance Of Them Chart 9Mutual Funds##BR##Obey Their Owners ... Confounding Darwin's Intuition: Human Investors Never Learn Chart 10... Who Act On Real Emotion, Not Real Yields Kahneman and Tversky's groundbreaking research into decision-making under uncertainty revealed that our species is wired to make suboptimal investment decisions. Prospect theory, loss aversion and an unhealthy fixation on recent data all encourage retail investors to repeatedly shoot themselves in the foot. When it comes to asset allocation, households appear to focus exclusively on the action in the rear-view mirror (Chart 10). Retail investors as a group rotate between equities and fixed income retroactively, in response to recent past returns, not proactively in response to cues about future relative-return prospects. Investment Implications Despite the compelling intuition that investors should set their course by the interest-rate stars, there is no evidence in the flow of funds data that they have done so in the past. We posit that structural constraints on institutional investors, combined with humans' durable cognitive biases, offer no reason to expect that they will do so in the future. While there may not be any predictable rotation pattern, rising rates have given rise to a predictable performance pattern. Equities reliably perform better when real rates are rising by at least 100 basis points than they do when they're falling. Decomposition of S&P 500 returns indicates that the pattern holds because earnings rise a good bit more in rising-rate periods than multiples decline. And multiples don't always decline when rates rise, anyway; sometimes emotion overrides cash flow discounting mechanics. Investors should lighten up on Treasury allocations, while keeping the exposures they do hold at below-benchmark duration. They should not flee equities, however. Rates have not yet risen enough to cool off the economy in any material way, and we judge that they won't until somewhere around a 3.75% 10-year Treasury yield.2 Tight supplies in labor and goods markets will eventually stoke realized inflation and provoke the Fed into tightening enough to cut off the rally, but it hasn't happened yet, and it is far too early to de-risk portfolios on account of interest rates. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 An unusually large drop in rates may well be associated with economic distress, but default-adjusted bond payment streams are much less variable than near- and intermediate-term earnings estimates. 2 Based on the evolution of the Congressional Budget Office's longer-run estimates of real potential GDP growth, and the trend in our own model of long-term inflation expectations, it appears as if nominal potential GDP growth will be somewhere in the neighborhood of 3.75-4% next year. This is a much lower estimate than one would get from adding the Fed's 2% inflation target to the current rate of GDP growth, but we need to look past the immediate boost of the stimulus package to get a read on its longer-run effects. As with all of the estimates produced by our models, we look to it for a general guide to the future, not a precise point estimate.

Highlights We review last year's "Three Tantalizing Trades" and offer four additional ones: Trade #1: Long June 2019 Fed funds futures contract/short Dec 2020 Fed funds futures contract Trade #2: Long USD/CNY Trade #3: Short AUD/CAD Trade #4: Long EM stocks with near-term downside put protection Feature A Review Of Last Year's "Three Tantalizing Trades" I had the pleasure of speaking at BCA's last Annual Investment Conference on September 25th, 2017, where I presented the following three trade ideas (Chart 1): 1. Short December 2018 Fed funds futures We closed this trade for a profit of 70 basis points. Had we held on, it would be up 92 basis points as of the time of this writing. 2. Long global industrial equities/short utilities We closed this trade on February 1st for a gain of 12%, as downside risks to global growth began to mount. This proved to be a timely decision, as the trade would be up only 6.1% had we kept it on. We would not re-enter this trade at present. 3. Short 20-year JGBs/long 5-year JGBs This trade struggled for much of 2018 but sprung back to life in August. It is up 0.6% since we initiated it. We still like the trade over the long haul. Investors are grossly underestimating the risk that Japanese inflation will move materially higher as an aging population creates a shortage of workers and a concomitant decline in the national savings rate. We also think the government will try to egg on any acceleration in consumer prices in order to inflate away its debt burden. In the near term, however, the trade could struggle if a combination of weaker EM growth and an increase in the value of the trade-weighted yen cause inflation expectations to decline. Four Additional Trades Trade #1: Long June 2019 Fed funds futures contract/short December 2020 Fed funds futures contract Investors expect U.S. short-term rates to rise to 2.38% by the end of 2018 and 2.85% by the end of 2019. The 47 basis points in tightening priced in for next year is less than the 75 basis points in hikes implied by the Fed dots. Investors appear to have bought into Larry Summers' secular stagnation thesis. They are convinced that short rates will not be able to rise above 3% without triggering a recession (Chart 2). Chart 1Revisiting Last Year's Three Tantalizing Trades Chart 2Markets Expect No Fed Hikes Beyond Next Year Regardless of what one thinks of Summers' thesis, it must be acknowledged that it is a theory about the long-term drivers of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019 compared to 3.6% of GDP in 2015. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP next year, little changed from a deficit of 0.9% it ran in 2015 (Chart 3). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is rising faster than GDP (Chart 4). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 5). Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 6). Faster wage growth will put more money into workers pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current ratio of household net worth-to-disposable income (Chart 7). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 3U.S. Fiscal Policy Is More Expansionary Than The Euro Area Chart 4U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 5U.S. Credit Growth Will Remain Strong Chart 6Quits Rate Is Signaling That There Is Upside For Wage Growth Chart 7The Personal Savings Rate Has Room To Fall A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 A more hawkish-than-expected Fed will bid up the value of the greenback. A stronger dollar, in turn, will undermine emerging markets, which have seen foreign-currency debts balloon over the past six years (Chart 8). The deflationary effects of a stronger dollar and falling commodity prices could temporarily cause investors to price out some hikes over the next few quarters. With that in mind, we recommend shorting the December 2020 Fed funds futures contract, while going long the June 2019 contract. The first leg of the trade captures our expectation that the market will revise up its estimate the terminal rate, while the second leg captures near-term risks to global growth. The gap between the two contracts has widened over the past few days as we have prepared this report, but at 21 basis points, it has plenty of room to increase further (Chart 9). Chart 8EM Dollar Debt Is High Chart 9U.S. Rate Expectations Are Too Low Beyond Mid-2019 Trade #2: Long USD/CNY China's economy is slowing, which has prompted the government to inject liquidity into the financial system. The spread in 1-year swap rates between the U.S. and China has fallen from about 3% earlier this year to 0.6% at present, taking the yuan down with it (Chart 10). It is doubtful that China will be willing to match - let alone exceed - U.S. rate hikes. This suggests that USD/CNY will appreciate. China's real trade-weighted exchange rate has weakened during the past four months, but is up 25% over the past decade (Chart 11). U.S. tariffs on $250 billion (and counting) of Chinese imports threaten to erode export competitiveness, making a further devaluation necessary. Chart 10USD/CNY Has Tracked China-U.S. Interest Rate Differentials Chart 11The RMB Is Still Quite Strong President Trump will oppose a weaker yuan. However, just as China's actions earlier this year to strengthen its currency did not prevent the U.S. from imposing tariffs, it is doubtful that efforts by the Chinese authorities to talk up the yuan would appease Trump. Besides, China needs a weaker currency. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46%. As a matter of arithmetic, national savings need to be transformed either into domestic investment or exported abroad via a current account surplus. China has concentrated on the former strategy over the past decade. The problem is that this approach has run into diminishing returns. Chart 12 shows that the capital stock has risen dramatically as a share of GDP. As my colleague Jonathan LaBerge has documented, the rate of return on assets among Chinese state-owned companies, which have been the main driver of rising corporate leverage, has fallen below their borrowing costs (Chart 13).2 Chart 12China's Capital Stock Has Grown Alongside Rising Debt Levels Chart 13China: Rate Of Return On Assets Below Borrowing Costs For State-Owned Companies Now that the economy is awash in excess capacity, the authorities will need to steer more excess production abroad. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. The dollar is currently working off overbought technical conditions, a risk we flagged in our August 31st report.3 That process should be complete over the next few weeks. Meanwhile, hopes of a massive Chinese stimulus focused on fiscal/credit easing will fade. The combination of these two forces will push up USD/CNY above the psychologically-critical 7 handle by the end of the year. Trade #3: Short AUD/CAD A weaker yuan will raise raw material costs to Chinese firms. This will hurt commodity prices. Industrial metals are much more vulnerable to slower Chinese growth than oil. Chart 14 shows that China consumes close to half of all the copper, nickel, aluminum, zinc, and iron ore produced in the world, compared to only 15% of oil output. Our expectation that developed economy growth will hold up better than EM growth over the next few quarters implies that oil will outperform industrial metals. Oil is also supported by a tighter supply backdrop, particularly given the downside risks to Iranian and Venezuelan crude exports. A bet on oil over metals is a bet on DM over EM growth in general, and the Canadian dollar over the Australian dollar specifically (Chart 15). Canada exports more oil than metals, while Australian exports are dominated by ores and metals. In terms of valuations, the Canadian dollar is still somewhat cheap relative to the Aussie dollar based on our FX team's long-term valuation model (Chart 16). Chart 14China Is A More Dominant Consumer Of Metals Than Oil Chart 15Oil Over Metals = CAD Over AUD Chart 16Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar The loonie has been weighed down by ongoing fears that Canada will be left out of a renegotiated NAFTA. However, our geopolitical strategists believe that the Trump administration is trying to focus more on China, against whom the case for unfair trade practices is far easier to make. The U.S. has already negotiated a trade deal with Mexico and an agreement with Canada is more likely than not. If a new deal is struck, the Canadian dollar will rally. We recommended going short AUD/CAD on June 28. The trade is up 3.4%, carry-adjusted, since then. Stick with it. Trade #4: Long EM stocks with near-term downside put protection It is too early to call a bottom in EM assets. Valuations have not yet reached washed-out levels (Chart 17). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 18). However, at some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. During the 1990s, this capitulation point occurred shortly after the collapse of Long-Term Capital Management in September 1998. EM equities fell by 26% between April 21, 1998 and June 15, 1998. After a half-hearted attempt at a rally, EM stocks tumbled again in July, falling by 35% between July 17 and September 10. The second leg of the EM selloff brought down the S&P 500 by 22%. Thanks to a series of well-telegraphed Fed rate cuts, global markets stabilized on October 8th (Chart 19). The S&P 500 surged by 68% over the next 18 months. The MSCI EM index more than doubled in dollar terms over this period. EM stocks outperformed U.S. equities by a whopping 71% between February 1999 and February 2000. Europe also outperformed the U.S. starting in mid-1999. Value stocks, which had lagged growth stocks over the prior six years, also finally gained the upper hand. Chart 17EM Assets: Valuations Not Yet At Washed Out Levels Chart 18EM Bottom Fishers Still Abound Chart 19The ''Great Equity Rotation'' Is Coming: A Roadmap From The 1990s The "Great Equity Rotation" is coming. All the trades that have suffered lately - overweight EM, long Europe/short U.S., long cyclicals/short defensives, long value/short growth - will get their day in the sun. Investors can prepare for this inflection point by scaling into EM equities today, but guarding against near-term downside risk by buying puts. With that in mind, we are going long the iShares MSCI Emerging Market ETF (EEM), while purchasing March 15, 2019 out-of-the-money puts with a strike price of $41. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too simulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Please see China Investment Strategy Special Report, "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging," dated August 29, 2018. 3 Please see Global Investment Strategy Weekly Report, "The Dollar And Global Growth: Are The Tables About To Turn?" dated August 31, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights So What? President Trump is treating the midterm election as a hurdle. Once cleared, he will restart "Maximum Pressure" policy towards China and Iran that will induce market volatility. The outcome of the election, however, has only a marginal investment relevance. Why? A Democrat-held Congress will not have the votes to overturn President Trump's signature economic policies: tax cuts, deregulation, and stimulus. Removal from power requires 67 votes in the Senate, out of the reach for Democrats. President Trump will pursue aggressive foreign and trade policies, regardless of the midterm outcome. As such, the midterm outcome is a non-diagnostic variable. Also... Rising stroke-of-pen risk, combined with President Trump's unorthodox foreign and trade policies, will likely intensify following the midterm election. Therefore, it is difficult to "buy on (midterm-related) dips," despite our call that the election does not matter. Feature Should investors care about the upcoming midterm election? The answer is yes, but marginally. A gridlocked Congress, our most likely outcome, is historically less positive for equities than an electoral outcome that results in a unified executive and legislature (Chart 1). The reality, however, is that economic and monetary variables are overwhelmingly more important for investors than politics.1 Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of gridlock and reduced uncertainty in the 12-months following presidential and midterm elections.2 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 1A Unified Congress Is A Boon For Stocks Table 1A Divided Government Is Marginally Negative For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of the timeframe, but only just. Could 2018 be different? Given the extraordinary level of polarization - captured in Chart 2 by the difference in presidential approval by party identification - this time could, indeed, be different. But, we do not think it will be. As we discussed last week,3 Democrats in Congress would not be able to impact the three crucial pillars of the Trump Reflation Trade: De-regulatory agenda: The executive branch is in charge of the deregulatory agenda, which investors should note kindled corporate animal spirits on day 1 of the Trump presidency (Chart 3). Chart 2Presidential Approval Variance Signals Peak Polarization Chart 3Trump's Mere Election Stoked Animal Spirits Tax cuts: Without 67 votes in the Senate, the Democrats cannot overturn a presidential veto that is certain to be used on any tax-hikes as long as President Trump is in power. They won't even get to the 60 votes necessarily to invoke cloture and thus avoid a Republican filibuster on tax, immigration, or other policy reforms. Fiscal policy: We see no chance of the Democratic Party becoming the party of fiscal discipline ahead of the 2020 election. Voters are not demanding budget discipline, despite the obvious rise in budget deficits (Chart 4), so why would the Democratic Party nail itself to the fiscal conservative cross over the next two years? What of the impeachment risk? There is no empirical evidence that impeachment proceedings have any impact on U.S. equity markets.4 And we would fade any concerns that an impeachment push would cause President Trump to seek relevancy abroad with aggressive foreign and trade policies because we expect him to do so regardless of the midterm outcome! Nonetheless, we do think that investors are in for a mild surprise this November (Chart 5). First, the data suggests that Democrats will have a wave election. In fact, we are raising our probability of a Democratic House victory to 70%, largely in line with current expectations. Second, we are also raising our call on the Senate to a "too-close-to-call." Essentially, we think that the Democratic Party may be able to pick up a Senate seat, which would be an extraordinary outcome given that they are defending 26 seats out of the 35 in contention.5 While such an electoral surprise may not have immediate investment implications in 2018 and 2019, it could have implications beyond 2020. The Senate electoral math significantly changes in 2020, with Republicans currently set to defend 21 seats out of 33 in contention (a number that could grow due to retirements). A Democratic sweep of U.S. institutions in 2020 could significantly alter the long-term earnings outlook in the U.S., especially if America's center-left party swings further to the left by then. Such an outcome would put an end to the two-decade long divergence in profits and wages as share of the total economy (Chart 6). But more on that at a later point. In this report, we focus on the upcoming election itself. Chart 4Voter Fiscal Preferences Are Not Fixed Chart 5Our Senate Call Is Out Of Consensus Chart 6What Is Not Sustainable Will Stop Midterm Election: The Twenty Charts To Watch History is stacked against the Republican Party. Chart 7 shows that the president's party has lost, on average, 24 seats since the 1950 midterm election. Only Clinton in 1998 - at the top of an epic bull market and with an approval rating of 66% (!) - and Bush Jr. in 2002 - following a once-in-a-generation terrorist attack on the U.S. homeland - managed to eke out positive gains. Even in those Goldilocks conditions, Clinton's Democrats only picked up a paltry five seats in the House (none in the Senate), while Bush's GOP gained two Senate and eight House seats. Chart 7Midterm Elections Normally Spell Doom For The President's Party Polls suggest that this time will not be different. Both the congressional generic ballot (Chart 8) and President Trump's popularity - at just 39% - (Chart 9) are signaling a wave election for the Democrats. Chart 8Polling Gives Dems The Advantage Chart 9President Trump Is A Drag On The GOP... But what about the roaring economy? Astonishingly, economic performance has a negative correlation with electoral outcomes in congressional elections (Chart 10)! This data point is so counterintuitive that it must be wrong. At the very least, history suggests that there is no clear relationship between the economy and congressional returns. Chart 10...Whereas The Economy Is Unlikely To Provide A Tailwind The economy only matters when things are going wrong. Current polls, in other words, are already pricing in a solid economic context, with the Democratic lead over the Republicans having narrowed from double-digits since the economy began roaring in January (Chart 11). At this point, however, it is highly unlikely that two more months of solid economic performance will have much of an effect on voter preferences. In fact, the importance of the economy, jobs, and budget deficits to voters has been declining since 2014 (Chart 12). Chart 11The Economy Is Already Baked In The (Polling) Cake Chart 12Voters Care Less About Economic Issues In addition, investors should remember that voter experience of the economic recovery is highly polarized. During Obama's presidency, Republican voter consumer sentiment and expectations were at recession levels. Magically, on November 8, 2016, both Republicans and Democrats changed their sentiment (Chart 13). Independent voters are, unsurprisingly, somewhere in the middle. Chart 13Voters Cannot Agree On Economic Performance Anyway Primary election turnouts are confirming that the economy is not the primary driver of voter enthusiasm. Democrats have seen 8.9 million more voters vote in the 2018 primaries, compared to the 2014 midterm election. Meanwhile, GOP voters - who are presumably more enthused about the economy - have only seen a pickup of 3.8 million new primary voters. The pattern of primary voting is similar to the one in 2010, when the Tea Party revolt energized the Republican base in opposition to President Obama. In 2010, Republicans increased primary turnout in 186 congressional districts compared to the 2006 election. Satisfied with President Obama's win in 2008, Democrats only increased the primary turnout in 35 districts. As a result, the GOP picked up 63 House seats and gained control of the lower chamber of Congress. This time around, the numbers foreshadow a similar wave, but in favor of the left. Democrats have seen their turnout increase in 123 electoral districts, compared to the 2014 election. This includes 20 of the most competitive races this year. Republicans, meanwhile, have seen an increase in enthusiasm in only 19 congressional districts this year. The death knell for Republicans in the House of Representatives, in our view, will be the abnormally large number of retirements (Chart 14). Incumbency has a powerful effect in congressional races. On average, incumbents easily win over 90% of their races for the House (Chart 15). Chart 14Double More GOP Retirements This Year Chart 15Incumbents Normally Carry The Day The average margin of victory for the Republican representatives not running for re-election in the 42 electoral districts in 2016 was 28.3%6 (Table 2). This sounds like too high of a hurdle for Democrats to leap over. However, that is precisely what Democratic candidates have done in the House and Senate special elections in 2017 and 2018. The average GOP lead in those races is down from 29.2% in 2016 to just 8.5% today, a 20.7% swing (Table 3). This math explains why the Cook Political Report, the premier U.S. election forecasting consultancy, sees the number of competitive Republican-held seats more than doubling in 2018 (Chart 16), whereas the number of competitive Democratic-held seats has collapsed. Table 2Republicans Not Seeking Re-Election In 2018 Table 3Non-Incumbent Republicans Lost 20% Advantage In Special Elections Our Senate model is similarly flashing red for the Republican Party. Despite an overwhelming structural advantage in the 2018 cohort - having to only defend nine seats - our model is predicting that the Democrats will hold all their Senate seats and pick up one (in Nevada) (Chart 17). Chart 16Number Of GOP Seats At Risk Has More Than Doubled! Chart 17Our Senate Model Is Generous To The Democrats We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.7 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. The results of our "beta" model, expressed as a margin of victory by the Republican candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate. Highly concerning for President Trump and the GOP is that the Democratic Senate candidates have a healthy lead in three out of the four contested Midwest races (Chart 18), suggesting that Trump's crossover appeal to blue-collar voters is not working when he is not the candidate (or perhaps, even more alarming for the GOP, when Hillary Clinton is not his opponent). The only tight Midwest election is in Indiana, where Democratic incumbent Joe Donnelly's lead is within the margin of error. Another concern for the Republicans is that the Democrats have largely fielded centrist candidates in the House and Senate races. For example, former Tennessee Governor (2003-2011), Phil Bredesen, is a conservative Democrat currently leading in the polls against his Republican opponent. Democratic candidates for election in Republican-held Arizona and Nevada are similarly centrists and thus competitive (Chart 19). Furthermore, in the 42 seats where Republicans are fielding non-incumbents, our research suggests that Democrats only fielded 14 left-wing/progressive candidates.8 Despite the media's focus on left-wing/progressive candidates - such as Alexandria Ocasio-Cortez in the Bronx or Ayanna Pressley in Boston - the vast majority of Democratic candidates in the non-coastal U.S. have been centrists. This means that GOP candidates will have very few "lay-ups" in November. Putting it all together, we would give Democrats a 70% chance of picking up the necessary 23 seats to take over the House. In the Senate, the next two months will determine the outlook for GOP candidates. Investors should fade the message from the current polling - and thus our model - as voters have paid very little attention to local races before Labor Day. However, if the current trajectory in the congressional generic poll and Trump's popularity holds until November, the likelihood of a GOP hold in the Senate will fall. For President Trump, a result where he loses the House and the Senate would be a political disaster. Should investors prepare for the volatility of impeachment in that case? The midterm election is a non-diagnostic variable. The Senate requires 67 votes to convict the president and thus remove him from power. A 50 +1 majority will not help Democrats get to that level any more than a 50 -1 minority would. They will need Republican Senators to join them in the impeachment endeavor. For that to happen, Republican voters will have to lose confidence in President Trump in droves, as they once did in President Nixon. As Chart 20 clearly illustrates, we are nowhere near that point today. Chart 18The Midwest: Is The Trump Magic Gone? Chart 19The Sun-Belt: No Place To Hide For The GOP? Chart 20Trump Is Not Nixon (Yet) Investment Implications: Much Ado About Nothing Putting it all together, this year's midterm election has a good chance of dominating the news flow by producing a shocking electoral surprise. In the immediacy of an outcome that hands the control of the entire Congress to the fired-up Democrats, it would be smart to bet on a brief risk asset pullback. However, the Democrats will not be able to unravel any of President Trump's main economic policies. In fact, investors may be presented with higher odds of an infrastructure plan and even of an immigration deal, if President Trump faces reality and comes to the middle ground on some of his demands (as President Clinton did after his disastrous 1994 midterm election). As for impeachment and the risk of President Trump "seeking relevancy abroad," our high conviction view is that he will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. In fact, President Trump has explicitly threatened an increase of the tariff rate to 25% by the end of the year in order to put more pressure on Beijing. The increase in the tariff rate would be a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election date. This is not a coincidence, but a product of White House design. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not.9 Given the potential impact on domestic gasoline prices, the White House has decided to coincide the pressure on Tehran with the end of the election season. The midterm election, therefore, is important only in terms of timing. Once it is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes (and we agree) led to a breakthrough in North Korea policy. Unfortunately for the markets, we do not expect that the maximum pressure tactic will work as smoothly with Iran and China.10 The final risk to markets is the creeping "stroke of pen" risk from potential regulation of technology enterprises. Joseph Simons, the Trump appointed new chair of the Federal Trade Commission, recently said that "the broad antitrust consensus that has existed... for about 25 years is being challenged... the U.S. economy has grown more concentrated and less competitive."11 His comments have dovetailed the threat to FAANG stocks that exists from a shift in U.S. anti-trust enforcement, one that would take the anti-trust practice away from the consumer-friendly approach of the "Chicago School."12 Chart 21FAANG Stocks + Microsoft Have Dramatically Outperformed... Table 4...Generating 50% Of The 2018 S&P 500 Return! This is a big risk for the ongoing bull market as the reason why the S&P 500 has performed well is due to the performance of a few (enormous) technology stocks that have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history (Chart 21 and Table 4). And yet the one thing that a plurality of Democrats and Republicans seem to agree with is that major tech companies should be regulated (Chart 22). Privacy advocates - who tend to lean left or libertarian - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs post midterm election. In fact, it is the one thing that Trump, and his supporters may (Chart 23), have in common with a potentially left-leaning Congress. Chart 22Majority Of Americans Want Tech Regulated Chart 23Conservatives Distrust Tech Companies How should investors play the midterm election? It is tough to say. We do not think the Democrats' takeover of Congress will be a catalyst for the markets. However, there are a slew of concerning geopolitical developments that will accelerate post-election, some specifically because President Trump will become more aggressive following the electoral hurdle. As such, we would be cautious. While it may serve investors well to "buy on dips" related to the fear of a "Socialist" takeover of Congress, it will be difficult to disassociate such hysteria from genuinely bearish narratives emanating from the Middle East, with trade policy, or stroke of pen risks looming over FAANG stocks. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 2 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 3 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 We are counting Senators Angus King (Maine) and Bernie Sanders (Vermont) as "Democrats" in this tally as they both caucus with the Democratic Party and generally vote very much in line with their left-leaning peers. 6 Excludes Pennsylvania due to redistricting in early 2018, and OK-01, as the candidate ran unopposed. 7 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincident index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 8 This number is largely our judgement call based on the statements from the Democratic primary winners. However, the fact that there is no unified progressive movement - akin to the 2010 Tea Party revolution - confirms our view. 9 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 11 Please see Diane Bartz, "Trump's antitrust enforcer considers shifting up a gear," dated September 13, 2018, available at reuters.com. 12 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com.