Fixed Income

Highlights Duration Strategy: The recent market turmoil was a long overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. Country Allocations: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Feature Repricing "Central Banker Puts" Can Be Painful By a quirk of our scheduling, we have not published a regular Weekly Report since September, during what became a period of more turbulent global financial markets. While we trust that our clients have enjoyed the Special Reports that we have published instead, we are certain that many are asking an obvious question: have the more jittery markets triggered any change in BCA's views on global fixed income? The answer is "no". Just like the sharp "Vol-mageddon" risk asset selloff back in early February, the origin of the recent volatility spike was soaring U.S. Treasury yields driven by a rapid upward revision of Fed rate hike expectations (Chart of the Week). We had been expecting such an adjustment based on our positive assessment of the underlying momentum of both economic growth and inflation in the U.S. This remains a critical underpinning for our below-benchmark call on U.S. duration exposure, and our increased caution on U.S. spread product. Chart of the WeekRisk Assets Struggling As Bond Yields Rise There is more to the story than just the Fed, however. Throughout the course of 2018, we have been warning that global central banks moving away from accommodative monetary policies would be the greatest threat to market stability. This is not only a story of Fed rate hikes. A reduction in the pace of asset purchases by the European Central Bank (ECB) and the Bank of Japan (BoJ), combined with outright contraction of the Fed's swollen balance sheet, has created a backdrop more conducive to volatile spikes - especially if the global economy is losing upward momentum at the same time. The OECD leading economic indicator has been steadily declining throughout 2018, a reflection of the more challenging backdrop for non-U.S. growth. It is no coincidence that, without the support from accelerating liquidity or positive economic momentum, many of last year's best performing investments (Italian government bonds, the Turkish lira, Emerging Market (EM) hard currency corporate debt) have been some of 2018's worst (Chart 2). Investors were willing to ignore the poor structural fundamentals underlying those markets when times were good, but have been much more cautious in 2018 with a less supportive macro environment. Chart 2The Darlings Of 2017 Are The Duds Of 2018 While there have been numerous political headlines that have caused bouts of market turbulence in the past few months - the escalating U.S.-China "tariff war", the Italian fiscal debate with the European Union - the short-term impact of these moves is magnified when global monetary policy is being tightened and global growth is cooling. The reason why central banks have been forced to turn more hawkish (or at least less dovish) is that diminished economic slack has forced their hands. For policymakers with an inflation-targeting mandate, the Phillips curve framework remains the primary analytical framework. When they see low unemployment, they get nervous. When they see low unemployment AND rising inflation, then become hawkish. Three-quarters of OECD countries now have an unemployment rate below the estimate of the full-employment NAIRU - the highest level in a decade - and realized inflation rates are accelerating in the major developed economies (Chart 3). Our own Central Bank Monitors are signaling the need for tighter monetary policy in most countries, while yields at the front-ends of government bond curves are steadily rising. Chart 3Central Bankers Still Believe In The Phillips Curve Looking ahead, we continue to see more upward pressure on global bond yields in the next 6-12 months. Market pricing for the future policy actions of the major central bank did not move much even with the surge in volatility earlier this month. The markets now understand that the "policymaker put" that central bankers have implicitly sold to investors has a much lower strike price when labor markets are tight and inflation is accelerating. It will take much larger selloffs to cause central banks to become less hawkish. We still see the decisions we made in late June, moving to a more cautious recommended stance on overall risk in fixed income portfolios, as appropriate. Staying below-benchmark on overall global duration risk, while underweighting those countries where the central banks are under the greatest pressure to tighten policy, is the most sensible way to allocate a fully-investment government bond portfolio. That means underweighting the U.S. and Canada and overweighting Japan, Australia and the U.K. (Chart 4). In terms of credit, we are maintaining an overall neutral stance, but favoring the U.S. versus European equivalents and a maximum underweight on EM credit. Chart 4Interest Rates Remain Unfazed By More Jittery Markets Bottom Line: The recent market turmoil was a long-overdue risk asset correction that does not change any fundamental underpinnings for rising global bond yields. Stay below-benchmark on overall global duration exposure, concentrated in an underweight stance on U.S. Treasuries. The Most Important Charts For Our Most Important Country Duration Views When determining our recommended fixed income country allocation, there are a few critical indicators we are watching to assess if those views should be maintained. We now go over each of those indicators for the most important developed economy bond markets: U.S. (Underweight): Watch TIPS Breakevens & The Employment/Population Ratio U.S. Treasuries have been the one major government bond market this year that has seen a rise in both inflation expectations and real yields. The breakeven inflation rate implied by the spread between 10-year nominal Treasuries and TIPS has gone up from 1.97% to 2.10% since the start of 2018, while the real 10-year TIPS yield has climbed from 0.44% to 1.09% over the same period. The rise in inflation expectations has occurred alongside an acceleration of U.S. economic growth and a generalized rise in inflation pressures. Reliable cyclical leading indicators like the ISM Manufacturing index and the New York Fed's Underlying Inflation Gauge are pointing to an acceleration of U.S. core CPI inflation towards the 2.5-3% range over the next year (Chart 5). This would be enough to push 10-year TIPS breakevens comfortably into the 2.3-2.5% range that we deem consistent with the Fed's price stability target (core PCE inflation at 2%). Chart 5U.S.: Both Real Yields & Inflation Expectations Are Rising Any larger move in inflation expectations would only occur if the Fed were to accommodate it by not continuing to hike rates at the current 25bps/quarter pace. That is unlikely with the strength of the U.S. labor market suggesting that the Fed is behind the curve on rate hikes. The U.S. employment/population ratio for prime age (25-54 years old) workers has almost returned back to the peak levels of the mid-2000s near 80% (bottom panel). The Fed had to push the real funds rate to over 3% during that cycle to get policy to a restrictive setting above the Fed's estimate of the r-star neutral real rate. While it is unlikely that the Fed will need to push the real funds rate to as high a level as in the mid-2000s, the current real rate has not even caught up to the Fed's r-star estimate, which is starting to slowly increase alongside the stronger U.S. economy. That implies a higher nominal funds rate would be needed to push up the real rate to neutral levels, with even more nominal increases needed if inflation continues to accelerate. With only 62bps of rate hikes over the next year currently discounted in the USD Overnight Index Swap (OIS) curve, there is scope for Treasury yields to rise further over the next 6-12 months. Core Europe (Underweight): Watch Realized Inflation Relative to ECB Forecasts In the euro area, the evolution of unemployment, wage growth and core inflation compared to the ECB's positive forecasts will be the critical driver of the future direction of government bond yields. In its latest set of economic projections published last month, the ECB expects the overall euro area unemployment rate to be 8.3% in 2018, 7.8% in 2019 and 7.4% in 2020.1 With the actual unemployment rate falling to 8.1% in August, the realized outcomes are already exceeding the ECB's forecasts (Chart 6). The same can be said for euro area wages, where the growth in compensation per employee (2.45%) is already running above the 2018 ECB projection of 2.2%. The ECB expects no acceleration of wage growth in 2019 (2.2%), but a further ratcheting up in 2020 (2.7%). Chart 6Euro Area: Expect Higher Yields If ECB Forecasts Materialize In a recent Special Report, we identified a leading relationship between wage growth and core HICP inflation in the euro area of around nine months.2 This would suggest that core HICP inflation should rise towards 1.5% within the next six months based on the current acceleration of wage growth (second panel). This would be above the ECB's current projection for 2018 (1.1%), but in line with the 2019 forecast (1.5%). Core inflation is projected to rise to 1.8% in 2020. If unemployment and inflation even just match the ECB's forecasts, there is likely to be a material repricing of core European bond yields through higher inflation expectations. At 1.7%, 10-year EUR CPI swaps are well below the +2% levels that occurred during the past two ECB rate hike cycles in the mid-2000s and 2010-11 (third panel). Both wage and core price inflation in the euro area were around the ECB's current 2019-2020 projections during both of those prior tightening episodes, suggesting that the past may indeed be prologue when it comes to inflation expectations. Given growing U.S.-China trade tensions, and uncertainties over the future path for Chinese economic growth, there is a risk that the ECB's growth and unemployment forecasts are too optimistic. The euro area economy remains highly levered to exports, and to Chinese demand in particular. Furthermore, the ECB continues to provide very dovish forward guidance, with no rate hikes expected until at least September 2019. Yet with a mere 12bps of rate hikes over the next year currently discounted in the EUR OIS curve, there is scope for core European bond yields to rise further over the next 6-12 months if euro area inflation surprises to the upside. Italy (Underweight): Watch Non-Italian Bond Spreads & The Euro The Italian budget battle with the European Union has been a gripping drama for investors in recent months. Italian bond yields have been under steady upward pressure, with the benchmark 10-year yield getting as high as 3.78%. Yet the story remains as much about sluggish Italian growth as it is about Italian fiscal policy. The populist Italian government has pushed for larger deficits, but has toned down the anti-euro language that dominated the election campaign earlier this year. This is why there has been very minimal contagion from higher Italian bond yields into other Peripheral European bond yields or euro area corporate bond spreads, or into the euro itself which remains very firm on a trade-weighted basis (Chart 7). Chart 7Italy: A Story Of Weak Growth, Not Euro Break-Up We continue to view Italian government bonds as a growth-sensitive credit instrument, like corporate bonds. In other words, faster Italian economic growth implies greater tax revenues, smaller budget deficits and a less worrisome trajectory for Italy's debt/GDP ratio. The opposite holds true when Italian economic growth is slowing. This is why there is a reliable directional relationship between Italy-Germany bond yield spreads and the OECD's leading economic indicator (LEI) for Italy (top panel). With the Italy LEI still in a downtrend, we do not yet see a cyclical case for shifting away from an underweight stance on Italian government bonds. Yet if the 10-year Italian yield were to reach 4%, the implied mark-to-market loss would wipe out the capital of Italy's banks, who own large quantities of government bonds. In that scenario, the ECB would likely get involved to stem the crisis, possibly by further delaying rate hikes of ramping up asset purchases. This would especially be likely if there was significant widening of non-Italian credit spreads and a sharply weaker euro. Hence, watch those markets for signs that the Italy fiscal crisis could trigger a monetary policy response. U.K. (Overweight): Watch Real Wage Growth & Business Confidence In the U.K., our non-consensus call to stay overweight Gilts has not been based on any long-run value considerations. Real yields remain depressed and the Bank of England (BoE) has kept monetary policy settings at extremely accommodative levels. The BoE continues to expect that a rise in real wage growth is likely due to the very tight U.K. labor market. This would support consumer spending and eventually require higher interest rates. The only problem is that this is happening very slowly. The annual growth in U.K. wage growth is now up to 3.1%, the fastest rate since 2008. This is above the pace of headline CPI inflation of 2.5%, thus real wages are finally starting to perk up (Chart 8). A continuation of this trend would feed into faster consumer spending and, eventually, trigger BoE rate hikes. Chart 8U.K.: Brexit Uncertainty + Middling Inflation = BoE Doing Little One other big impediment to the BoE turning more hawkish is the uncertainty over the U.K. government's Brexit negotiations with the EU. The extended Brexit drama has weighed on both U.K. business and consumer confidence, both of which have struggled since the 2016 Brexit vote (third panel). With the March 2019 deadline for the U.K. "officially" leaving the EU fast approaching, the odds of no deal being reached in time are increasing. U.K. Prime Minister Theresa May is desperately trying to avoid a no-deal Brexit, but such an outcome would create further instability in U.K. financial markets and close any near-term window of opportunity for the BoE to try and hike rates. For now, we see the depressed confidence from Brexit uncertainty offsetting the bump up in real wage growth, leaving Gilts on a path to continue modestly outperforming as they have throughout 2018 (bottom panel). An announcement of a Brexit deal would be a likely trigger for us to downgrade Gilts to neutral, and perhaps even to underweight given the developing uptrend in real wage growth. Bottom Line: Continue allocating duration risk for global government bond portfolios in favor of countries where central banks will have difficulty raising interest rates (Australia, U.K., Japan core Europe) relative to countries where rate hikes are more necessary and likely to happen (U.S., Canada). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1https://www.ecb.europa.eu/pub/pdf/other/ecb.ecbstaffprojections201809.en.pdf 2 Please see BCA Foreign Exchange Strategy/Global Fixed Income Strategy Special Report, "Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan?", dated October 5th 2018, available at fes.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The investors we met with last week were generally optimistic: No one expects a recession before 2020, and none of the investors we spoke with confessed to underweighting equities. Our concerns about inflation are not broadly shared. We encountered a lot of pushback over our sugar-rush view of the stimulus package: Despite its undeniable short-term benefits, we expect the stimulus package will prove self-defeating for the U.S. economy over the intermediate- and long-term horizon. The view that bond yields are capped seems to have become entrenched: Demographics and the capital-lite Internet-era template are powerful long-run drags on bond yields, but we think yields will rise before they fall, if indeed they can fall in the face of gaping deficits. There is plenty of scope for the Fed to surprise investors: Our terminal fed funds rate expectation of 3.5% - 4% makes us a clear outlier. Feature We spent two days last week discussing market views with clients in and around Philadelphia. There is no substitute for face-to-face meetings, and we always benefit from the exchange of ideas, perspectives, and anecdotes. We also find that investors are eager to hear what's on the minds of their peers and competitors, and get a read on BCA clients' sentiment. This week's report is given over to what we saw, said, and heard about the topics we spent the most time discussing. Fiscal Stimulus The investors we met were constructive about the economy. Our view that there will be no U.S. recession before 2020 is squarely consensus, and client questions about the potential for the expansion to stretch into 2021 and beyond outnumbered questions about the factors that could force us to speed up our recession timetable. We were regularly asked to defend our view that the fiscal stimulus package, while boosting growth in 2018 and 2019, will ultimately reduce potential GDP growth in the intermediate and long term. The questions about the stimulus were especially interesting given that the glass-half-empty view has not generated any internal controversy. The tax-cut package has delivered in spades in the short term. S&P 500 earnings per share are growing at better than a 20% clip; CEO confidence is high; and small businesses, per the NFIB survey, are beside themselves with glee (Chart 1). The IMF projects that the stimulus package will deliver fiscal thrust of 0.8% and 0.9% of GDP in 2018 and 2019, respectively. Real GDP growth is likely to hover around 3% this year and next, as opposed to the 2% level that has been the post-crisis rule. Chart 1Small Business Owners Are Giddy GDP growth is simply the sum of growth in the working-age population and gains in productivity. Policymakers are powerless to do anything now about the last three decades' birth rate, and it appears unlikely that immigration will pick up the slack, but a reduced income tax burden may encourage more people to enter the work force, and/or remain in it longer, increasing labor supply. Increases in the capital stock promote productivity gains, as output rises when workers are better equipped. Net-net, lower individual and corporate income-tax rates, and the immediate expensing of corporate investments, are solid supply-side policy that should help nudge trend GDP higher. There is a fly in the ointment, however. Without commensurate cuts in federal spending, the tax cuts are poised to blast the budget deficit to extremely high levels (Chart 2). If Congress doesn't change its spendthrift ways in the next several years, federal debt relative to GDP will break its World War II-mobilization record by 2030 (Chart 3). The adverse consequences would include diverting a greater share of federal revenues to debt service, constraining spending to respond to recessions or natural disasters, crowding out private investment, and reducing national savings.1 Chart 2So Much For Saving For A Rainy Day Chart 3On The Road To Record Indebtedness The relationship between the size of the capital stock and productivity advances is clear, but average productivity growth has been mired below 1% for close to five years despite a bounce in capex (Chart 4). Perhaps the problem recently has been the capital stock's inability to keep up with employment gains - capital per worker has been shrinking for seven years (Chart 5) - but anyone forecasting an investment-driven increase in productivity should be aware that such a forecast swims against the tide. On a peak-to-peak basis, annualized growth in real private nonresidential investment has been soft for 40 years, with the exception of the cycle that encompassed the computing revolution (Chart 6). The ability to expense investments immediately will boost the capital stock, but we're not counting on a sizable effect. Experience suggests that buybacks, which have next to no multiplier effect on the overall economy, will siphon off much of the increased cash flow accruing from the tax cuts. Chart 4Has Productivity Failed To Respond To The Bounce In Capex ... Chart 5Productivity Held Back By Lack Of Investment Chart 6Capex Cycles Ain't What They Used To Be Adaptive Expectations And The Bond Market The investment roadside has grown thick over the last ten years with failed predictions about higher interest rates, and investors have taken notice. Perhaps no view is so widely shared as the notion that Treasury yields are unlikely to go much higher. Fed haters and other wild-eyed prophets of zero-interest-rate-policy and quantitative-easing doom have been roundly discredited. The adaptive expectations hypothesis, which holds that economic actors slowly adjust their expectations of future events based on how they've been surprised by past iterations of those events, supports the idea that ten years of listless inflation have investors geared up for more of the same. There are sound fundamental reasons to expect lower rates in the future.2 Demographics will pressure the size of the labor force, lowering potential growth; new-era services businesses don't need to borrow as much as the manufacturing behemoths of yesteryear; and widening inequality will redirect wealth from consumers to savers. In the long term, the rate-suppressing factors may be able to offset the upward pressure on rates exerted by the ballooning budget deficit. But inflation is likely to be the biggest driver in the near term. We argued last week that the labor market is so tight it squeaks. The headline unemployment rate is at a 50-year low, and "hidden" unemployment - accounting for involuntary part-time workers and discouraged workers who have given up actively looking for work - is back down to its 1999-2000 and 2006-07 lows. The Phillips Curve has been the object of considerable derision since the crisis, but we are fervent believers in the law of supply and demand. When the demand for workers outstrips supply, compensation will rise (Chart 7). Chart 7Employees Are Gaining Bargaining Power We also expect the fiscal stimulus package to push prices higher. Force-feeding stimulus to an economy that's already operating at full capacity is a sure-fire recipe for inflation. The consequences will be unpleasant for bond investors, especially those holding long-dated Treasuries. One can make the case that slowly adapting expectations contributed significantly to both the three-decade Treasury bear market from the fifties to the eighties, and the 35-year bull market ended in July 2016. Investors were insufficiently compensated for inexorably rising inflation throughout the sixties and seventies (Chart 8), then overcompensated for ever-waning inflation after the Volcker Fed broke its back (Chart 9). If our take is correct, the pendulum is poised to swing back to insufficient compensation for a while. Chart 8A Nightmarish Stretch For Bondholders ... Chart 9... Planted The Seeds For A 35-Year Dream Never Forget At The Fed If all of the strategists at BCA submitted a forecast of the terminal fed funds rate in the current cycle, we expect the mean would settle around 3.5%. We are in the more aggressive camp that foresees a 3.5 to 4% range. If our concerns about inflation turn out to be well founded, we think the FOMC will be forced to intensify its rate-hiking campaign to ensure that it keeps the inflation genie from getting out of the bottle. A great deal of blood was spilled in the first three years of Paul Volcker's chairmanship (1979-82), and the Federal Reserve as an institution wants to make sure it wasn't spilled in vain, regardless of any individual voter's qualms about overdoing hikes.3 Updating Fama And French While discussing the value factor and its extended underperformance, some investors questioned the ongoing relevance of Fama and French's book-to-price metric. For companies that operate on the Internet and derive their value from network effects rather than investments in plant, property and equipment, they asked, is book value a truly useful measure? Although we note that virtual value is not an entirely new phenomenon (the dot.com-era darlings' charms didn't always show to best advantage on drab balance sheets), we have some sympathy for this line of reasoning. There is surely scope for book-to-price to make capital-lite companies appear to be more richly valued than they really are. The custom value and growth indexes created by our Equity Trading Strategy colleagues offer a way around the problem. They augment price-to-tangible-book with four additional metrics - trailing P/E, forward P/E, price-to-sales, and price-to-cash-flow - in an attempt to better suss out the presence of value. They also compare individual companies only to companies within their own sector to construct strictly equally sector-weighted indexes. The sector-by-sector construction methodology should help mitigate biases that emerge from balance-sheet differences across industries. Investment Implications The path of the fed funds rate is at the heart of our assessment of when the business cycle and the equity bull market will end. If the Fed maintains its gradual pace through all of 2019, hiking the fed funds rate by 25 basis points every quarter, we estimate that monetary policy will turn restrictive about a year from now. That projection leads us to expect that the expansion will stretch into 2020, and that the equity bull market has another year left to run. If the Fed speeds up its timetable, or spooks markets and drives up long rates by telegraphing a higher terminal rate, we would likely bring forward our expectations for the end of the equity bull market, and the onset of full-on spread widening. If our out-of-consensus take on inflation is proven correct, the Fed will act more hawkishly than markets expect. Treasuries would suffer as markets recalibrated their Fed expectations, especially at the long end. We reiterate our fixed-income and Treasury underweights, and continue to recommend investors maintain below-benchmark-duration positioning. We believe it is very unlikely that developments overseas will deter the Fed from pursuing measures to rein in worryingly high inflation, and caution investors from placing too much stock in the notion of an "EM put." The Fed's mandate is exclusively domestic, and events outside of the United States' borders matter only to the extent that they threaten to impinge on the U.S. economy. Chart 10Half Of The Way To Overweight Finally, we note that it's not all gloom and doom, blood-red CNBC graphics aside. As the S&P 500 declines, its prospective returns rise if we're correct that the bull market has another year left in it. We are buyers of a correction (a 10% peak-to-trough decline), and will return to overweighting U.S. equities if the S&P 500 dips into the 2,600-2,640 range, bounding correction territory and the year-to-date lows (Chart 10). Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the July 2018 Bank Credit Analyst Special Report, "U.S. Fiscal Policy: An Unprecedented Macro Experiment," available at www.bcaresearch.com, for a comprehensive analysis of the fiscal stimulus and its effects. 2 Please see the March 13, 2015 Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," available at gis.bcaresearch.com. 3 Volcker was burned in effigy, the Speaker of the House agitated for his resignation, and aggrieved farmers blockaded the Federal Reserve building with tractors in protest of the Fed's stern anti-inflation policies. A summary of the pressures the Volcker Fed faced can be found in the article, "Volcker's Announcement of Anti-Inflation Measures," available at https://www.federalreservehistory.org/essays/anti_inflation_measures, accessed October 16, 2018.

Special Report

Highlights A supply-driven spike in oil prices in early 2019 is now a highly likely scenario. This represents a potential risk to our current high-conviction view that global bond yields will continue to rise over the next year. Oil prices north of $100/bbl would have negative implications for global growth, especially with a rising U.S. dollar likely to magnify the inflationary impact outside the U.S. A spike in oil prices could alter the recent positive correlation between global bond yields and oil (through higher inflation expectations), even turning into a negative correlation (through weaker expected economic growth). The most reliable historical correlations suggests that more volatile oil prices will lead to greater volatility for both bond yields and corporate credit spreads. Feature The BCA house view remains unequivocally bond bearish, led by additional upside potential for U.S. Treasury yields. The Fed will continue to deliver a steady pace of rate hikes over at least the next year in response to a strong U.S. economy that is fueled by fiscal stimulus and operating well beyond full employment. U.S. bond markets are not discounting enough potential tightening and inflation expectations remain below levels consistent with the Fed's 2% inflation target, so Treasury yields have room to rise further. While we are comfortable with our high-conviction bearish view on government bonds, we recognize that it is prudent to look for potential scenarios that could derail our base-case scenario. Especially since our once out-of-consensus expectation of higher global yields is now a widely-held view among investors, with Treasury yields breaking out to new cyclical highs in recent weeks. One such risk could come from a spike in oil prices in early 2019, and its potential aftermath. A confluence of geopolitical (Iran, Venezuela) and monetary policy risks (Fed tightening, rising U.S. dollar) will likely stoke oil price volatility next year. This will eventually lead to higher bond market volatility both in developed markets (DM) and emerging markets (EM) - a relationship that has had a far more reliable correlation over time than the direct relationship between oil prices and yields (Chart 1). Chart 1Oil Vol & Bond Vol Are Linked In this joint Special Report, BCA's Commodity & Energy Strategy and Global Fixed Income Strategy services explore how a changing relationship between oil and interest rates could affect the future behavior of global bond markets and, by association, returns to fixed income portfolios. Growing Odds Of A 2019 Oil Price Spike Global oil markets are tightening. While oil demand growth is slowing somewhat, exports from two of OPEC's largest producers - Iran and Venezuela - are falling precipitously. U.S. sanctions against the former, and the unabated collapse in the latter's economy will together remove some 2mm barrels/day (b/d) of supply from an already tight market next year. Global oil inventories are drawing down, while spare capacity is perilously low, leaving little in the way of readily available backup supply to deal with an unplanned production outage even in a minor oil-exporting state. The confluence of these factors is setting the global oil market up for a supply shock, which could take prices to $100/bbl in 1Q19 (Chart 2).1 Those high prices are likely to be sustained, and we expect Brent crude oil, the global benchmark, to trade at $95/bbl on average over the course of next year. Chart 2Get Ready For $100/bbl Oil In Q1 2019 Against this physical reality, the Fed remains set to continue normalizing interest rates. With other major central banks remaining relatively accommodative, widening rate differentials (Chart 3) will continue to support the U.S. dollar (USD). This will, all else equal, increase the cost of oil in local currency terms outside the U.S., hitting EM economies particularly hard if the price move is both as large, and as rapid, as we expect. Chart 3Rate Differentials Will Remain USD-Supportive It is important here to differentiate between a steady demand-driven rise in the price of oil and a rapid supply-driven oil price spike. The former can be bond-bearish by pushing up the inflation expectations components of global bond yields at a time when strong economic growth is also pushing up real bond yields. An oil price spike, however, can eventually produce a DIS-inflationary impulse by depressing real economic growth and destroying oil demand, which ultimately lowers oil prices, inflation expectations and real yields. The IMF, in its most recent World Economic Outlook, highlighted a scenario for 2019 where a big enough rise in oil prices could even cause the Fed to reverse its rates-normalization policies.2 While this is not BCA's base case view, a period of sharply higher oil prices in 1Q19 followed by lower prices in 2H19 would whipsaw global oil markets and raise oil price volatility. History suggests that bond price volatility is likely to also increase in the process, both for government bonds (through more uncertainty over the future path of inflation and policy rates) and corporate bonds (though more uncertainty over future economic growth). Expect Higher Bond Volatility As Oil Volatility Rises Since the end of the Global Financial Crisis (GFC), oil volatility has strongly influenced volatility in DM and EM bond markets. Indeed, we find all grades of corporate and junk bonds grouped together are highly correlated with oil volatility in the post-GFC period. We expect this to continue going forward, as oil inventories are drawn down globally to meet consumer demand for refined petroleum products like gasoline, diesel fuel, chemicals and plastics. The drawdown in global inventories shows up in a backwardated oil-price forward curve, which reflects the increasing inelasticity of supply.3 This means prices have to adjust more frequently and sharply to equilibrate available supply with demand, producing higher volatility in oil prices (Chart 4). Chart 4Implied Volatilities Will Rise As OECD Storage Falls Using principal components analysis (PCA), we find a high pairwise correlation between oil and bond volatility since 2010. The first principal component (PC) of all grades of corporate and junk bonds grouped together varies strongly with oil volatility, with a correlation of 0.80. Importantly, this component explains 91% of the variability in the group (Chart 5).4 EM bond spreads for smaller issuers like Chile, Peru, Hungary, Poland, Turkey, Indonesia, Mexico, Colombia, and Malaysia are also heavily influenced by greater variability of oil prices, with the first PC of this group highly correlated with oil volatility. Chart 5Oil Volatility Leads To Bond Volatility It comes as no surprise that our U.S. Bond Strategy group, headed by Ryan Swift, has found that lower-quality corporate bonds (i.e., junk) have a high correlation with oil volatility, as do lower-quality corporate spreads (Chart 6). As Ryan noted in a recent report: "there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa. ... The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads."5 Chart 6Higher Oil Vol = Wider Junk Spreads Oil Volatility Leads To Credit Spread Widening Thus, the oil price spike that we are expecting in 2019 should make corporate bond investors more cautious on the outlook for credit spread and expected returns. BCA's bond strategists have already been expecting to shift to an underweight stance on U.S. corporate debt sometime in 2019 as the Fed moves to a restrictive monetary stance and investors begin to cut U.S. growth expectations and anticipate increased future credit downgrades and defaults. A sharp upward move in oil prices in 1Q19 may prove to be the trigger for that shift to a more bearish outlook on credit. Could An Oil Price Spike Change The Fed's Current Thinking? The combination of an oil price spike and a stronger USD that we anticipate would present a considerable headwind to EM economic growth. Econometric modelling work done by BCA Commodity & Energy Strategy shows that there is a strong correlation between EM growth and U.S. inflation (see Box 1).6 Correlation is not causation, of course, but there is a plausible mechanism for that correlation through the USD, which impacts both EM growth and U.S. inflation. Box 1 Modeling The Links Between The USD, EM & Inflation The two risks we highlight in this Special Report - an oil-price shock in 1Q19 that occurs while the Fed is tightening - have profound implications for EM economies, which makes them particularly important for fixed-income markets globally.7 The near-term effects of an oil-supply shock that quickly sent prices above $100/bbl will hit EM consumers particularly hard. Many governments relaxed or removed fuel subsidies shielding consumers from high oil prices following the OPEC-engineered oil-price collapse of 2014 - 16, which saw Brent crude oil prices - the global benchmark - fall from more than $110/bbl in 1H14 to close to $25/bbl in early 2016.8 An oil-price spike would consume a far larger share of EM households' disposable income now, and would reduce aggregate demand. The second risk - tightening of the Fed's monetary policy - is more complicated. The U.S. economy separated itself from the rest of the world with strong growth this year, partly aided by fiscal stimulus. As a result, the U.S. economy is operating beyond full employment, and wages are growing smartly. This growth allows the Fed to tighten monetary policy, which likely produces four policy-rate rate hikes this year, and, per our House view, four next year. On the back of the Fed's rates-normalization policy, the U.S. trade-weighted dollar appreciated ~ 8% this year. We expect continued strength next year. As the dollar strengthens, EM trade volumes slow. This is partly a result of rising local-currency costs ex U.S., as most commodities are priced in USD. Trade volumes - particularly imports - are closely tied to EM incomes: The World Bank estimates the income elasticity of trade in EM economies averaged 1.5% from 2000-07 p.a., and 1.2% from 2010-17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period.9 Falling trade volumes correspond with weakening or falling income in EM economies. Part of this likely is explained by the expansion and deepening of Global Supply Chains (GSCs) over the past two decades, which fueled the rapid rise in trade of intermediate goods globally, and EM incomes in the process.10 To examine the impact of a rising dollar on EM income, we estimated a regression for the level of EM import volumes using an ensemble of models for the broad trade-weighted index (TWIB) USD as an explanatory variable.11 Our modeling indicates that a 1% increase in our USD TWIB ensemble translates into a 0.33% decline in EM import volumes (Chart 7).12 Chart 7Strong Dollar Dampens EM Trade Volumes Downward Trend In EM Trade Will Continue As USD Strengthens ... Next, we wanted to take these results and have a closer look at inflation, since, as noted above, wage and price pressures have been transmitted globally through GSCs for the better part of the 21st century. This is a phenomenon that accelerates as GSCs are broadened and deepened. More precisely, we wanted to examine the global aspects of local inflation in DM and EM economies.13 To do this, we look at the level of the U.S. Consumer Price Index (CPI) as a function of EM import volumes. Our modeling indicates that a 1% change in the level of EM import volumes as a function of the USD TWIB translates to a change (in the same direction) in the level of U.S. CPI of between 0.15% and 0.25% - estimated over the post-GFC period (2010 to now). This reflects both the direct and indirect effects of EM incomes on domestic inflation in the U.S. (Chart 8): Chart 8U.S. CPI Vs EM Import Volumes U.S. CPI Vs EM Import Volumes A stronger USD lowers expected U.S. inflation by reducing the cost of imports. EM disposable income growth slows as the USD rises, because the local-currency costs of imports rise and consumes more of available household budgets. Our modeling isolates the common deterministic trend between the U.S. CPI and EM import volumes from the cyclical variations. In fact, these two variables expressed in levels exhibit a strong and stable common trend.14 The U.S. trade-weighted dollar index has already appreciated 8% this year, with more upside likely in the next 6-12 months (Chart 9).15 This would widen the existing sharp divergence between a strong U.S. economy and weaker non-U.S. growth, putting even more upward pressure on the USD. This would represent an additional tightening of U.S. monetary conditions on top of the Fed rate hikes that have already occurred since late 2015. Chart 9Expect Continued USD Appreciation BCA's bond strategy services have described a concept known as the "Fed Policy Loop" to explain the link between global growth divergences, a rising USD, financial market volatility and eventual shifts in the Fed's hawkish bias. Such a move occurred in late 2015/early 2016, when the Fed had to delay additional increases beyond the initial 25bp rate hike of the current tightening cycle because of a soaring USD and global financial market instability (Chart 10). Chart 10Is The Fed Policy Loop: Watch U.S. Credit Spreads The current backdrop shares some characteristics with that episode, in terms of growth divergences (top panel), USD strength and wider EM credit spreads (second panel). The missing piece today is a large widening of U.S. credit spreads, and U.S. credit market underperformance versus Treasuries (third panel). The U.S. economy is in a much healthier place now compared to three years ago, which is why credit spreads have remained much better behaved in 2018. The global backdrop is also far less disinflationary, with the global output gap now closed and inflation expectations drifting back towards pre-crisis levels consistent with central bank inflation targets (Chart 11). Investors should focus on U.S. corporate bond spreads for signs that a stronger USD is starting to impact U.S. corporate profits and future U.S. growth expectations. This would be the most likely potential trigger for the Fed to pause on its current tightening path, as occurred in early 2016 (bottom panel). Importantly, we firmly believe that the Fed's hurdle for backing off the rate hikes from a tightening of financial conditions is much higher now because the U.S. economy is stronger today. A "garden variety" equity market correction, without much widening of corporate spreads, will not be enough. Investment Implications What we have laid out in this report is a risk to the current BCA house views on global duration exposure (stay below-benchmark) and global credit exposure (stay neutral, but favoring the U.S. over Europe and EM) - a supply-driven spike in oil prices, combined with additional increases in the USD fueled by Fed tightening. The potential trigger for that oil spike is largely geopolitical, stemming from the likely loss of oil supply from Iran via U.S. sanctions and Venezuela through economic collapse. The timing of either outcome is difficult to pin down precisely, but sometime in the first quarter of 2019 is our current best guess for when oil prices reach $100/bbl. The key variables to watch will be the U.S. dollar. If it stays stable, then the impacts on global growth and U.S. inflation from the oil spike could be more modest. If the USD surges higher, then the negative impact on non-U.S. growth will eventually spill back into the U.S. economy. The combination of more volatile oil prices and a stronger USD would be a likely trigger for a surge in U.S. bond volatility and wider corporate bond spreads. Eventually, this could move the Fed to pause on its rate hike cycle and, at least temporarily, end the current bond bear market. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Our full oil-price forecast is available in the September 20, 2018, issue of BCA Commodity & Energy Strategy, in a report titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl." It is available at ces.bcaresearch.com. We will be updating our oil-price forecast next week. 2 Please see the IMF's World Economic Outlook for October 2018, which can be found here https://www.imf.org/en/Publications/WEO/ 3 Backwardation is a term of art in commodity markets used to describe an inverted forward curve - i.e., prompt prices for commodities delivered in the very near future trade higher than prices for commodities delivered further out in time. This is the market's way of signaling supplies are tight; storage holders are being incentivized to release oil in inventory via higher prices for prompt delivery. The opposite of this is referred to as a contango market (prompt prices are lower than deferred prices). Contango markets reflect well-supplied markets, as supply that cannot be immediately used must be stored for later use. In recent research, we were able to extend findings from academic studies that showed a non-linear relationship between oil volatility and the slope of the forward curve - highly backwardated and contango forward curves are accompanied by higher volatility in oil prices, due to the physical constraints on storage in such markets. 4 Principal components analysis (PCA) is a statistical technique used to reduce the most important information contained in a large number of correlated variables into a smaller number of common factors that explains the larger set. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Oil Supply Shock Is A Risk For Junk," dated October 9, 2018, available at usbs.bcaresearch.com. 6 EM trade volumes - particularly imports - are a key variable we use to track EM income levels. The World Bank estimates the income elasticity of trade averaged 1.5% from 2000 - 07, and 1.2% from 2010 - 17, meaning a 1% increase in income has led to a roughly 1.4% growth in trade over this period. Please see "Trade Wars, China Credit Policy Will Roil Global Copper Markets," in the June 21, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 10 of the 11 post-WW2 recessions in the U.S. were preceded by an oil-price spike. Since 1970, the combination of an oil-price spike and a Fed rate-hiking cycle resulted in recession. Please see "Oil-Supply Shock, Risking U.S. Rates Favor Gold As A Portfolio Hedge," published by BCA Research's Commodity & Energy Strategy on September 13, 2018. It is available at ces.bcaresearch.com. 8 Please see the Special Focus in the World Bank's January 2018 Global Economic Prospects entitled "With The Benefit of Hindsight: The Impact of the 2014 - 16 Oil Price Collapse." 9 We discuss this in "Trade Wars, China Credit Policy Will Roil Global Copper Markets," in the June 21, 2018, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 10 Please see "Global value chains and the increasingly global nature of inflation," by Raphael Auer, Claudio Borio, Andrew Filardo, published online April 28, 2017, by VOX, the CEPR Policy Portal. 11 We average estimates from five different USD regressions using monetary policy variables, commodity prices and momentum indicators. The period covered is the post-GFC (2010 to now). 12 The regression we estimate includes a trend variable, which allows us to separate out the cyclical aspects of trade (i.e., imports) alone. 13 Please see "The globalisation of inflation: the growing importance of global value chains," by Raphael Auer, Claudio Borio and Andrew Filardo, which was published by the Bank For International Settlements in January 2017. 14 We believe this reflects "hidden variables" that simultaneously drive U.S. inflation and EM incomes such as global growth and global money/credit growth. The coefficient range we report - 0.15% to 0.25% - controls for this. For a discussion of "hidden variables," please see Clive Granger's 2003 Nobel Lecture entitled "Time Series Analysis, Cointegration, and Applications." 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ...Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com.

Highlights Duration: Our Fed Policy Loop provides a framework for understanding last week's equity market correction and its implications for future Fed policy. So far, the equity sell-off is not severe enough to deter the Fed. Maintain below-benchmark portfolio duration. Credit: With the Fed lifting rates and the market still not priced for the likely pace of hikes, it is highly likely that we will witness further periods where corporate spreads and Treasury yields rise in unison. We recommend steps investors can take to insulate their portfolios from this risk. Inflation: The macroeconomic environment remains highly inflationary. The unemployment rate is very low and wage growth is rising. However, recent trends suggest that the year-over-year growth rate in core CPI will stay close to its current level, near the Fed's target, for the next six months. This will not alter the Fed's "gradual" +25 bps per quarter rate hike pace. Feature Chart 1The Second Rate Shock Of 2018 Last week's equity market rout was the second time this year that stocks reacted negatively to a sharp rise in bond yields (Chart 1). As was the case in February, our Fed Policy Loop remains the appropriate framework for understanding the relationship between bond yields and the stock market (Chart 2).1 It can be explained as follows: Chart 2The Fed Policy Loop Step 1: The perception of easy Fed policy fuels strong performance in the stock market. Rising stock prices and "easing financial conditions" cause economic growth to strengthen and sow the seeds of inflation. Step 2: Equity investors catch a whiff of inflation and start to price-in a more restrictive monetary environment. This leads to a stock market correction. Step 3: Falling stock prices and "tightening financial conditions" cause the Fed to downgrade its economic outlook and adopt a more dovish policy stance. Return To Step 1. The Equity Correction For Bond Investors At this juncture, the important question for bond investors is whether financial conditions have tightened enough to prompt a slower pace of rate hikes from the Fed. If so, then it might be appropriate to buy the dip in the bond market. We think such a move would be premature, for two reasons. First, the increase in bond yields that spooked the equity market was concentrated at the long-end of the curve and was fueled by Fed Chairman Powell's comment that the funds rate is "a long way from neutral." A steeper yield curve offsets some of the financial conditions tightening caused by falling stock prices (Chart 3). This is because it signals that monetary policy is becoming more accommodative - the fed funds rate is further below neutral than previously thought. This intuition is confirmed by the bounce in gold, a move that often coincides with an upward rerating of the neutral fed funds rate.2 Chart 3Steeper Curve Will Reassure The Fed Second, the amount of financial market pain that the Fed can tolerate depends on the economic environment. Our Fed Monitor is an indicator that is designed to signal whether the Fed should be hiking or cutting interest rates (Chart 4). It consists of 44 variables that can be grouped into three categories: Chart 4The BCA Fed Monitor Economic growth indicators (Chart 4, panel 3). Inflation indicators (Chart 4, panel 4). Financial conditions indicators (Chart 4, bottom panel). The overall Fed Monitor is currently deep in positive territory, signaling that rate hikes are appropriate. This is true despite the fact that the financial conditions component of the monitor has been falling (tightening) since the beginning of the year. Last week's equity market drop will not be reflected in the indicator until the end of the month, so further downside in the financial conditions component is forthcoming. But so far, tighter financial conditions have barely made a dent in the overall Fed Monitor because they have been offset by rising economic growth and stronger inflation. The conclusion is that the Fed is able to tolerate more market pain when growth is strong and inflation is high. Viewed through this lens, it is clear that a lot more market pain is required before the Fed backs away from its +25 bps per quarter rate hike pace. In fact, the Fed likely views some tightening of financial conditions as desirable, as long as the tightening doesn't severely impede the economic outlook. Just last week New York Fed President John Williams said: Normalization of the monetary policy, I think, has the added benefit of reducing somewhat, on the margin, some of the risk of imbalances in financial markets.3 While a few weeks ago, Fed Governor Lael Brainard noted: The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation.4 In other words, the Fed is increasingly cognizant of the fact that higher interest rates might be necessary to prevent excessive risk-taking in financial markets, even if inflation stays well contained near target. Unless financial conditions tighten so much that they cause the reading from our Fed Monitor to hook down, the Fed will be inclined to view the market correction as healthy. It is also important to note that while a large increase in long-maturity Treasury yields prompted last week's stock market action, the short-end of the yield curve didn't move much at all. In fact, overnight index swap forwards show that the market is just barely priced for three rate hikes during the next 12 months. According to our golden rule of bond investing, if you expect the Fed to lift rates by more than what is priced in for the next 12 months, you should keep portfolio duration low.5 Bottom Line: Last week's equity market sell-off is not enough to prompt the Fed to back away from its +25 bps per quarter rate hike pace. Investors should maintain below-benchmark portfolio duration. On The Correlation Between Yields And Spreads It wasn't just the stock market that struggled to digest higher Treasury yields last week. Corporate bond spreads also widened, particularly in the high-yield credit tiers (Chart 5). As with equities, this is the second time in 2018 that credit spreads widened sharply alongside higher Treasury yields. Chart 5Credit Also Struggling With Higher Rates Credit spreads and Treasury yields tend to be negatively correlated, a feature that benefits bond investors by reducing the volatility in corporate bond yields and total returns. But, as evidenced by last week's price moves, the correlation does occasionally turn positive. This is particularly damaging during sell-offs when both the rate and spread components of corporate bond yields rise. Chart 6 shows the frequency of negative and positive yield/spread correlations since 1994, using 3-month investment horizons. It shows that yields and spreads were negatively correlated in 64% of 3-month periods. Yields fell alongside tighter spreads in 23% of cases, while yields and spreads rose together only 13% of the time. Chart 6The Correlation Between Yields And Spreads Is Typically Negative Since those periods when both yields and spreads rise in unison are particularly damaging for bond investors, it is worth exploring them in more detail. Table 1 lists all 13 quarters since 1994 when junk spreads and duration-matched Treasury yields rose together. Using the logic of our Fed Policy Loop, we also identify three risk factors that might be associated with those periods. The main idea being that yields and spreads are likely to rise together in periods when the market starts to price-in much more restrictive monetary policy, and an earlier end to the economic recovery. The three risk factors we identify are: Table 1Periods When Both Treasury Yields And Junk Spreads Rose Since 1994 Whether the Fed raised interest rates during the investment horizon. Whether our 12-month Fed Funds Discounter increased during the investment horizon, meaning that the market priced-in a more aggressive near-term rate hike path. Whether the 5-year/5-year forward TIPS breakeven inflation rate rose during the investment horizon. Higher long-dated inflation expectations could cause the Fed to respond with a more restrictive monetary policy. The single most important risk factor is whether the Fed raised rates during the investment horizon. Nine of the 13 episodes coincided with a Fed rate hike, and three of the four episodes that didn't coincide with a rate hike occurred between Q2 2013 and Q4 2015. The fed funds rate was pinned at zero during that period, but the Fed was starting to turn hawkish by backing away from QE and preparing for liftoff. This leaves the second quarter of 2007 as the only true outlier. The Fed did not lift rates during this period, but it is clear that markets were spooked by overly restrictive Fed policy all the same. The 2/10 Treasury slope was only 7 bps at the start of the quarter, signaling that monetary policy was already quite restrictive. Meanwhile, long-dated inflation expectations rose during the quarter and the market went from discounting 60 bps of rate cuts during the next 12 months to only 17 bps. An inflationary shock when monetary policy is already restrictive is an environment where yields and spreads are very likely to rise at the same time. An upward move in our 12-month discounter is also associated with periods of rising yields and spreads in 9 out of 13 cases. This risk factor didn't work in Q4 2005 or Q2 2006, but once again it is quite clear that markets were spooked by overly restrictive monetary policy in those periods. The yield curve was inverted in both of those quarters, and the Fed lifted rates despite an inverted yield curve. That combination sends a clear signal to markets that the Fed is trying to choke off the recovery. The 12-month discounter also failed to send the correct signal in Q3 1999 and Q2 2000. In those cases the culprit appears to be a large jump in long-dated inflation expectations while the Fed was in the midst of a rate hike cycle. Since rate hikes should dampen inflation, rising inflation expectations suggest that rate hikes might need to speed up. Thinking about the current environment, we are very much in the danger zone where yields and spreads could rise at the same time. The Fed is in the midst of a rate hike cycle and the market is still not priced for quarterly rate hikes to continue for the next 12 months. Finally, long-dated TIPS breakeven inflation rates are almost back to the 2.3% to 2.5% range that is consistent with "well-anchored" inflation expectations (Chart 7). The higher long-dated breakevens get, the more likely it is that the Fed will respond forcefully to further increases. Chart 7Almost Re-Anchored With all three of our risk factors present, it is highly likely that we will see more episodes where credit spreads widen and Treasury yields rise. The risk will only dissipate once the full extent of the Fed's rate hike cycle is reflected in the Treasury curve, but we are not there yet. While this is not a great environment for bond investors, there are steps investors can take to limit the damage from periods of rising spreads and yields. First, investors should maintain portfolio duration at below-benchmark. Second, while it is too early in the cycle to completely abandon credit, a more defensive posture is advisable. We recommend only a neutral allocation to spread product, focused on the higher-quality credit tiers.6 To the extent possible, investors should also seek to focus their spread exposure at the long-end of the maturity spectrum, while also limiting overall portfolio duration by favoring the short-end of the Treasury curve.7 Inflation Uptrend On Hold Lost in the shuffle amidst last week's market turmoil, the consumer price index (CPI) for September was released and it delivered a soft month-over-month print for the second month in a row. The top panel of Chart 8 shows that the year-over-year trend in core CPI rose rapidly earlier in the year, but now appears to be leveling off. We do not envision a meaningful deceleration in core CPI, but it seems likely that the year-over-year rate of change will stay near current levels for the next six months. Chart 8Core Inflation & Pipeline Pressures Our Pipeline Inflation Indicator remains consistent with rising inflationary pressures in the economy, but it has softened of late. This is mostly due to weaker commodity prices (Chart 8, bottom panel). Further, our Base Effects Indicator - based on rates of change in the core CPI that have already been realized - is now consistent with a lower year-over-year core CPI growth rate six months from now (Chart 9).8 Chart 9Expect Year-Over-Year Core CPI To Flatten-Off, Or Even Decline Looking at the main components of core CPI, the last two monthly prints have been dragged down by the core goods component, with most of the weakness in apparel and used vehicles (Chart 10). This could reverse in the near-term as core goods prices catch up with import prices, which have been rising for some time. However, non-oil import prices have decelerated recently, on the back of a stronger dollar. In other words, any near-term increase in core goods inflation will probably not last very long. Chart 10Core CPI Components The core services excluding shelter component continues to have the most potential upside, since it is highly geared to rising wage growth. Shelter inflation, the largest component of core CPI, has been flat for some time and our models suggest this will continue to be the case for the next six months. Bottom Line: The macroeconomic environment remains highly inflationary. The unemployment rate is very low and wage growth is rising. However, recent trends suggest that the year-over-year growth rate in core CPI will stay close to its current level, near the Fed's target, for the next six months. This will not alter the Fed's "gradual" +25 bps per quarter rate hike pace. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 2 Please see BCA U.S. Bond Strategy Weekly Report, "A Signal From Gold?" dated May 1, 2018, available at usbs.bcaresearch.com. 3https://www.bloomberg.com/news/articles/2018-10-10/williams-says-fed-rate-hikes-helping-curb-financial-risk-taking 4https://www.federalreserve.gov/newsevents/speech/brainard20180912a.htm 5 Please see BCA U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com. 6 Please see BCA U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty," dated June 19, 2018, available at usbs.bcaresearch.com. 7 Please see BCA U.S. Bond Strategy Weekly Report, "Out Of Sync," dated July 3, 2018, available at usbs.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges," dated September 4, 2018, available at usbs.bcaresearch.com. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Rising U.S. bond yields will continue to put downward pressure on global stocks in the near term, but will not trigger an equity bear market until rates reach restrictive territory. We are still at least 12 months away from that point. The blowout in Italian bond yields has further to go, which will also weigh on global risk assets. Nevertheless, we would buy BTPs for a tactical trade if the 10-year yield rose above 4%, because at that level EU policymakers will call out the fire engines. We downgraded global equities from overweight to neutral in June, while maintaining our bias for DM stocks over EM stocks. Barring any major new developments, we would turn bullish again if global stocks were to fall by 8% from current levels. Remain cyclically underweight interest rate duration. We would move to neutral on duration if the U.S. 10-year yield were to rise to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Feature Bond Yields: Up, Up, And Away Global risk assets remained on the back foot this week. The MSCI All-Country World stock market index has now fallen by 6.3% in dollar terms since last Wednesday. Even the mighty S&P 500 has finally buckled under the pressure. The vulnerability of U.S. stocks had been accumulating beneath the surface for some time, as evidenced by the fact that the advance-decline line has been deteriorating since the late summer. The small cap Russell 2000 is down 11.3% from its August 31st highs (Charts 1A& 1B). Chart 1ABreadth Deteriorated In The Lead-Up To The Correction Chart 1BStocks Under Pressure Bond yields usually fall when equities swoon. This time around, it is the increase in bond yields itself that has undermined stocks. In the U.S., yields have risen in response to better-than-expected growth, a wider budget deficit, rising oil prices, and an increasingly hawkish Fed. In Italy, worries about debt sustainability have been the primary driver of rising yields. Neither factor spells doom for global risk assets. However, a period of indigestion is likely over the coming weeks, which could see global equities go down before they go up again. The U.S. Economy: Too Much Winning? We have argued for much of this year that investors were underappreciating the extent to which the Federal Reserve can raise rates without choking off growth. The past few weeks have seen a growing recognition among investors that the Fed may be behind the curve in normalizing monetary policy. This has led to a steepening in the expected path of U.S. short-term rates, which, together with an increase in the term premium, have pushed up yields at the longer-dated maturities. Both better economic data and Fedspeak contributed to the bond sell-off. On the data front, the non-manufacturing ISM index clocked in at 61.6. The all-important employment component of the index hit a record high. Confirming the encouraging labor market signal from the ISM, the unemployment rate fell to a 48-year low of 3.68% in September. While average hourly earnings ticked down to 2.75% on a year-over-year basis, this was entirely due to base effects. On a month-over-month basis, average hourly earnings have risen by 0.3% for three straight months. If this trend continues, the year-over-year rate will rise to 3.2% by the end of this year. Tellingly, recent wage growth has been concentrated among workers at the bottom of the income distribution (Chart 2). This is important because not only do the wages of low-income workers correlate better with labor market slack than those of high-income workers, but low-income workers are also more likely to spend the bulk of their paychecks. Chart 2Wage Growth Has Accelerated At The Bottom Of The Income Distribution Higher wage growth will boost consumer spending. Indeed, it is probable that consumption will rise more than income, given that the personal savings rate has plenty of scope to fall from the current elevated level of 6.6%. Rising wages will incentivize companies to invest more in labor-saving technologies, translating into an increase in capital spending.1 Add in ongoing fiscal stimulus, and we have a recipe for an overheated economy. Starstruck No More As of today, the market has priced in one Fed rate hike in December but only two rate hikes in 2019 (Chart 3). Investors expect no rate hikes in 2020 and beyond. That still seems implausible to us, which suggests that the bond sell-off has further to go. Chart 3The Market Still Thinks The Fed Can't Raise Rates Above 3% In contrast to the past, the Fed no longer seems interested in talking down rate expectations. Speaking with Judy Woodruff at The Atlantic Festival, Chairman Powell stated the Fed "may go past neutral, but we are a long way from neutral at this point, probably."2 Even uber-dove Chicago Fed President Charles Evans appears to have jettisoned his worries about deflation, noting in a speech last Wednesday that "I am more comfortable with the inflation outlook today than I have been for the past several years."3 The Fed has also increasingly downplayed the importance of estimates of the neutral rate of interest, the concept on which the long-term "dots" in the Summary of Economic Projections are based. The Fed's new mantra is that economic data, rather than some theoretical model, should guide monetary policy. Ironically, it was New York Fed President John Williams, who developed one of the most widely used models of r-star, the eponymously named Holston-Laubach-Williams model, that best articulated the Fed's position. At a speech last Monday, Williams argued that the neutral rate of interest, or r-star, has "gotten too much attention in commentary about Fed policy." He went on to say that "Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star."4 Trump And Bonds President Trump was quick to blame the Fed for this week's stock market sell-off. Within the span of 24 hours, he used the words "crazy," "loco," "ridiculous," "too cute," "too aggressive," and "big mistake" to describe recent Fed policy. We doubt Trump's rhetoric will have any immediate effect on Fed decision-making. But even if it did sway the Fed to slow the pace of rate hikes, the result will be higher bond yields, not lower yields. This is simply because any further delays in raising rates will lead to even more overheating, and ultimately, higher inflation and the need for higher rates down the road. Bond Sell-Off Will Produce A Correction In Stocks, Not A Bear Market At the height of this week's bond sell-off, the 10-year Treasury yield breached its 200-month moving average for the first time since ... October 1987 (Chart 4). While that sounds pretty ominous, keep in mind that the 10-year yield had reached almost 10% on the eve of the 1987 stock market crash, or about 6% in real terms. Chart 4Two Lines Meet After Three Decades As my colleague, Doug Peta, discussed two weeks ago, it is the level of interest rates that tends to matter more for stocks rather than the change in rates.5 Specifically, equity returns tend to be lowest at times when monetary policy is already in restrictive territory (Chart 5 and Tables 1 and 2). That was the case in 1987. It is not the case today. Chart 5The Fed Funds Rate Cycle Table 1Tight Policy Is Hazardous To Stocks' Health... Table 2...Especially In Real Terms The fact that stocks do worse in environments where monetary policy is tight makes perfect sense. A restrictive monetary policy is usually a prelude to a recession. As Chart 6 illustrates, bear markets and recessions almost always coincide, with the latter usually leading the former by about six-to-twelve months. None of our favorite leading recession indicators are flashing red now (Chart 7). Even the yield curve has steepened in recent weeks. Chart 6Recessions And Bear Markets Usually Overlap Still, higher long-term bond yields do reduce the long-term attractiveness of stocks compared with bonds. The S&P 500 earnings yield has risen modestly since 2016 due to the fact that earnings have grown somewhat more quickly than equity prices. However, the U.S. real 10-year yield has surged by almost 120 basis points over this period. On balance, this has caused the equity risk premium to decline (Chart 8).6 In order to bring the equity risk premium back down to mid-2016 levels, the S&P 500 would need to fall by about 15% from today's levels. We do not expect stocks to fall by that much, partly because the economic environment is more robust than back then, but a further drop of 5%-to-10% from current levels is certainly plausible. Chart 7A U.S. Recession Is Not Imminent Chart 8Stocks Versus Bonds Italy: Heading For A Debt Crisis? The rise in Treasury yields has reduced the attractiveness of other global government bond markets, causing them to sell off in sympathy. Notably, German bund yields have increased by 33 basis points since their May lows (Chart 9). Chart 9Global Bond Yields Moving Higher Rising German bund yields are bad news for Italy. All things equal, a higher "risk free" bund yield implies a higher Italian bond yield. To make matters worse, as Italian borrowing costs have risen, the perceived likelihood that Italy will be unable to repay its debt has increased. This has caused the spread between German bunds and Italian BTPs to widen, thereby magnifying the effect on Italian bond yields from the increase in risk-free yields. All this has happened at the worst possible moment. Italy's populist government and the European Commission are locked in a battle of wills over next year's budget. The Italian government is targeting a fiscal deficit of 2.4% of GDP for 2019, compared with a deficit of 0.8% that the outgoing caretaker government had proposed in May. Strictly speaking, the new deficit target is still consistent with the 3% limit under the Maastricht Treaty. Nevertheless, it is still causing consternation in Brussels. There are at least three reasons for this: While the government's program has a lot of specifics about how it will increase the deficit - more public investment; a universal minimum income scheme; the ability to retire earlier than under current law; corporate tax cuts; no VAT hike in 2019, etc. - it does not specify which items in the budget will be cut. The program also provides few details on revenue measures, other than proposing a one-off tax amnesty, which will arguably reduce tax receipts over the long haul. The proposed budget assumes real GDP growth of 1.5% in 2019. This is higher than the May projection of 1.4%, and well above the IMF's most recent projection of 1%. The government's real GDP projections for 2020-21 are also about 0.7 percentage points above the IMF's estimates. While Italy's proposed fiscal deficit is below the Maastricht Treaty limit, its current debt-to-GDP ratio of 132% is well above the ceiling of 60% (Chart 10). This implies that Italy should be aiming for a smaller deficit target than what it is currently proposing. Chart 10Italy's Public Debt Mountain We expect the Italian government to ultimately acquiesce to the EU's demands, but not before the bond vigilantes have pushed them into a corner. For their part, the EU establishment would love nothing more than to embarrass the Five Star-Lega coalition in order to send a message to voters across Europe about the dangers of voting for populist parties. This means that the Italian 10-year yield may need to break above 4% - the level at which Italian banks would likely be technically insolvent based on the market value of their BTP holdings - before a compromise is reached. We would put on a tactical trade to buy 10-year BTPs at that level, but not before then. Investment Conclusions Goldilocks will survive, but the next couple of months will be challenging. Our soon-to-be-launched MacroQuant model is signaling a bearish outlook for stocks over the next 30 days (Chart 11). On the bond side, the model currently pegs the fair value for the U.S. 10-year yield at 3.7% (Chart 12). Bond sentiment is quite bearish at the moment, which makes a brief countertrend bond rally quite likely. However, the cyclical trend in yields remains to the upside. Chart 11MacroQuant* Recommends That Caution Is Warranted Towards Equities Chart 12MacroQuant Sees 10-Year Treasury Yields Still Below Fair Value We stated last week that investors should consider scaling back risk if they are currently overweight risk assets. We continue to favor this more cautious stance. For the first time in over a decade, short-term U.S. rates are above the dividend yield on the S&P 500 (Chart 13). Holding a bit more cash is finally an attractive option, at least for U.S.-based investors. Chart 13Cash Anyone? If the sell-off in global equities continues, it will present a buying opportunity, given that the next major global economic downturn is probably at least another two years away. Barring any major new developments, we would turn bullish on stocks again if the MSCI All-Country World Index were to fall by 12% 10% 8% from current levels.7 We would recommend that investors move from an underweight to a neutral interest rate duration position in global bond portfolios if the U.S. 10-year Treasury yield rose to 3.7%. We are still bullish on the dollar, but would shift to neutral if the DXY rose above 100. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 It is true that additional investment spending will raise aggregate supply, but normally it takes a while for that to happen. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see "WATCH: Powell says Fed is focused on 'controlling the controllable,' not politics," PBS News Hour, October 3, 2018; and Jeff Cox, "Powell says we're 'a long way' from neutral on interest rates, indicating more hike are coming," CNBC, October 3, 2018. 3 Charles Evans, "Monetary Policy 2.0?" OMFIF City Lecture on the U.S. Economic Outlook, London, England, October 3, 2018. 4 John C. Williams, "Remarks at the 42nd Annual Central Banking Seminar," Bank for International Settlements, October 1, 2018. 5 Please see U.S. Investment Strategy Special Report, "When Will Higher Rates Hurt Stocks?" dated September 24, 2018; and Special Report, "Revisiting The Fed Funds Rate Cycle," dated September 3, 2018. 6 For this exercise, we define the equity risk premium as the difference between the S&P 500 earnings yield (the inverse of the forward P/E ratio) and the real 10-year bond yield (using CPI swaps as our measure of expected inflation). 7 The perils of writing a report during a week when markets are moving fast. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades