Fixed Income

Please note that a Special Alert titled "Brazil: A Regime Shift?" discussing investment implications of the weekend elections was published on Tuesday. Highlights The combination of rising U.S. bond yields and slumping growth in EM/China heralds further downside in EM risk assets and currencies. Watch for a breakdown in Asian risk assets and currencies. As a market-neutral trade for the next several months, we recommend going long Latin American and short emerging Asian stocks in common currency terms. We are downgrading Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. Feature U.S. bond prices have broken down, and yields have broken out (Chart I-1). The bond selloff will continue as U.S. growth is very strong and inflationary pressures are accumulating. Chart I-1U.S. Bond Yields Have Broken Out, More Upside How will EM financial markets react to a further rise in U.S. bond yields? If EM growth were robust and fundamentals healthy, financial markets in developing countries would have no problem digesting higher U.S. interest rates. However, the fact is that EM fundamentals are poor and growth is weakening. Consequently, financial markets in the developing world are very vulnerable to higher U.S. bond yields. For now, U.S. bond yields will continue to rise, the U.S. dollar will strengthen further, and the EM bear market will endure. Stay short/underweight EM risk assets. Understanding The Nexus Between EM Assets And U.S. Bonds Rising U.S. bond yields pose a threat to EM risk assets if the former leads to a stronger U.S. dollar and by extension weaker EM currencies. Notably, risks to EM share prices will magnify if dollar borrowing costs for EM (corporate and sovereign bond yields) increase further (Chart I-2). In short, if rising U.S. bond yields are not offset by narrowing EM credit spreads, EM dollar bond yields will climb. This in turn will weigh on EM share prices. Chart I-2Rising Dollar Borrowing Costs: A Bad Omen For EM Stocks Chart I-3 highlights that the divergence between U.S. and EM share prices this year can be attributed to the decoupling in their credit spreads. Chart I-3Diverging Credit Spreads Between EM & U.S Credit spreads, meanwhile, are steered by EM exchange rates (Chart I-4). When EM currencies depreciate, debtors' ability to service U.S. dollar debt worsens, and credit spreads widen to reflect higher risk. The opposite also holds true. Chart I-4EM Credit Spreads Are A Function Of EM Currencies Overall, getting EM exchange rates right is of paramount importance. Hence, a vital question: Do EM currencies always depreciate when U.S. bond yields are rising or the Federal Reserve is tightening? Chart I-5 suggests not. Before 2013, EM currencies appreciated with rising U.S. bond yields. Since 2013, the correlation has been mixed. Chart I-5No Stable Relationship Between U.S. Bond Yields & EM Currencies The key difference between these periods is the performance of EM/Chinese economies. When EM/China growth is robust or accelerating, financial markets in developing economies have no trouble digesting higher U.S. interest rates and their currencies tend to appreciate. By contrast, when EM/China growth is weak or slumping, EM asset prices and currencies tumble regardless of the trajectory of U.S. interest rates. A pertinent question at the moment is why robust U.S. growth is not helping EM weather higher U.S. interest rates. The caveat is that EM as a whole is more exposed to the Chinese economy than the American one. Hence, barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. This is why we have been focusing on China's growth dynamics. Bottom Line: Desynchronization between the U.S. and Chinese economies will persist. The resulting combination of rising U.S. bond yields, a stronger greenback and depreciating EM currencies foreshadows further downside in EM risk assets. Emerging Asia: Do Not Catch A Falling Knife The latest export data from Korea and Taiwan point to a continued slowdown in their exports (Chart I-6). Corroborating the deepening slump in Asian growth and global trade, emerging Asian equity and credit markets are plunging. In particular: Chart I-6Global Trade Is Slowing The relative performance of emerging Asian stocks versus the global equity benchmark failed to break above important technical long-term resistance lines earlier this year, and will likely breach below their early 2016 lows (Chart I-7). Chart I-7Emerging Asian Equities Vs. Global: Further Underperformance Ahead Both high-yield and investment-grade emerging Asian corporate dollar-denominated bond yields continue to climb - a worrisome development for emerging Asian share prices (high-yield corporate bond yields are shown inverted in Chart I-8). Chart I-8Rising Corporate Bond Yields In Emerging Asia = Lower Stock Prices The equity selloff in emerging Asia is broad-based. Chart I-9 shows that the emerging Asian small-cap equity index is in freefall. Chart I-9Emerging Asian Small Caps Are In Freefall Net earnings revisions in China, Korea and Taiwan have dropped into negative territory (Chart I-10). Chart I-10Net Earnings Revisions Are Negative In China, Korea And Taiwan The Chinese MSCI All-Share Index - all stocks listed on the mainland and offshore (worldwide) - has plunged close to its early 2016 lows (Chart I-11). Chart I-11Chinese Broad Equity Index Is Back To Its 2016 Lows In China, the property market and construction remain at substantial risk. The budding slump in the real estate market will likely offset the government spending stimulus on infrastructure investment. Plunging share prices of property developers listed in both onshore and in Hong Kong point to a looming major downtrend in real estate market (Chart I-12). Chart I-12An Imminent Slump In Chinese Real Estate? For Asian equity portfolio managers whose mandate is to make a decision on Hong Kong and Singapore stocks, we recommend downgrading Hong Kong equities from neutral to underweight while maintaining Singapore at neutral within an Asian and overall EM equity portfolio. Our basis is that rising interest rates in the U.S. will translate into higher borrowing costs in Hong Kong due to the currency peg (Chart I-13). Simultaneously, Hong Kong's economy will suffer from a slowdown in China. Hence, a combination of weaker growth and rising borrowing costs will spell trouble for this interest rate-sensitive bourse. Chart I-13Higher U.S. Rates = Higher Hong Kong Rates Bottom Line: Equity and credit markets in emerging Asia are trading extremely poorly, and further downside is very likely. This week, we are downgrading allocations to Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. A Relative Equity Trade: Short Asia / Long Latin America Common currency relative performance of emerging Asian versus Latin American stocks has broken down (Chart I-14). We reckon emerging Asian equities are set to underperform their Latin American peers for the next several months. Chart I-14Long Latin American / Short Emerging Asian Stocks The main culprit will likely be further depreciation in the RMB and an intensifying economic downturn in Asia, which will propel emerging Asian currencies and share prices lower. In regard to Latin America, elections in Mexico and Colombia have produced governments that will on the margin be positive for their respective economies. In Brazil too, first round election results are pointing to a market friendly result. We have been shifting our country equity allocation in favor of Latin America at the expense of Asia since late last year. In particular, we downgraded Chinese stocks in December 2017, Indonesian equities this past May and the Indian bourse last week. At the same time, we have been raising our equity allocation to Latin America by upgrading Mexico to overweight in April 2018, Colombia last week and Brazil earlier this week.1 Given we are also overweight Chilean stocks, our fully invested EM equity model portfolio noticeably overweights Latin America versus Asia. Notwithstanding our broad underweight in emerging Asia, we are still overweight Korea, Taiwan and Thailand within an EM equity portfolio. However, these overweights are paltry relative to both the size of the Asian equity universe and our overweights in Latin America. Bottom Line: Go long Latin American and short emerging Asian stocks in common currency terms as a trade for the next several months. Our Fully-Invested Equity Model Portfolio Chart I-15 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-15EMS's Fully-Invested Model Equity Portfolio Performance We make explicit country equity recommendations (overweight, underweight and neutral) based on qualitative assessments of all relevant variables - the business cycle, liquidity, currency risks, policy, politics, valuations, and the structural backdrop among other things - for each country. This model portfolio is not a quantitative black box, but rather a combination of several factors: macro themes on the overall EM space, in-depth research on each individual country and various quantitative indicators. The table with our recommended country equity allocation is published at the end of our weekly reports (please refer to page 11). This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Staring At A Grey Swan?" dated October 4, 2018 and Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018; links are available on page 11. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Jair Bolsonaro, an ex-army captain and a right-leaning, law-and-order candidate has won a surprising victory in the first round of the Brazilian presidential election (Chart I-1). Bolsonaro came within striking distance of 50%, but did not cross that threshold, which means that the second round will go ahead on October 28. Given that he only needs another 4% to gain a majority of votes, his victory in the second round is now the most likely outcome by far. Importantly, the results of the congressional election similarly saw a swing to the right in both legislative houses. Chart I-1Bolsonaro Outperformed In The First Round What are the prospects for pro-market structural reforms amid this apparent regime shift in Brazilian politics? How should investors be positioned over the coming months? In the short term, a Bolsonaro presidency will boost business and market sentiment. This is mainly due to the right-leaning balance of parties in Congress and hence Bolsonaro's ability to form a majority coalition. This should lead to an outperformance of Brazilian assets relative to EM on expectations of reforms being passed and implemented. BCA's Emerging Markets Strategy service recommends upgrading Brazil to an overweight within EM equity, credit, and local fixed-income portfolios. However, in the longer term, we expect that Bolsonaro's presidency will still be constrained on social security reforms. It is still not clear if Brazil's median voter is demanding the kind of policies touted by Bolsonaro's economic advisors. Given Bolsonaro's populism, he may not be willing to expend his political capital on painful and unpopular reforms. In light of this, investors with a 2-5 year horizon should be wary of increasing their absolute exposure to Brazilian assets. Private investors looking for long-term exposure to Brazil should be especially concerned about Bolsonaro's anti-democratic, pro-military inclinations. A New Political Regime... Bolsonaro outperformed expectations in the first round by winning 46% of the popular vote, soundly beating his main rival Fernando Haddad of the left-wing Worker's Party. Polls over the past few weeks had seen him pegged at around 30%. Yet, Sunday night's results showed Bolsonaro beating all pollsters' expectations and nearly gaining the victory in the first round. Table I-1First Round Turnout Was Low In Contrast To Pass Elections Notably, and in contrast to previous elections, overall turnout for the first round was low, standing at just 79% (Table I-1). This played into Bolsonaro's hands. Even though there will be strategic voting in the second round - and our expectation is that most left-leaning voters will switch to Haddad, the remaining left-wing candidate - Haddad's chances look slim. He needs a mass wave of Lula supporters to turn out for the vote. The fact that they did not in the first round bodes ill for him. Thus, Bolsonaro stands at strong odds of becoming Brazil's next president. Attention will turn to the mandate that Bolsonaro will receive over the next four years. In our view, the factors below will be key: Short-term constraints have fallen off: The surprising surge in right-leaning parties at the congressional level suggests that President Bolsonaro will have no immediate legislative constraints to his agenda. He will be free to pursue his policy preferences relatively unimpeded. Chart I-2Chamber Of Deputies Results This is due to both legislative houses shifting towards the right, giving Bolsonaro a mandate to form a majority right-wing government for the first time since 1998 (Chart I-2). So far, 63% of seats in the lower house have gone to center-right and right-wing parties (according to our back-of-the-envelope calculation). If all of these parties joined into a coalition it would represent a historically strong mandate. Markets will surely interpret this as a positive development. However, not all of these parties will necessarily join Bolsonaro. Moreover, reforms requiring a constitutional amendment, such as the all-important reform of Brazil's unsustainable pension system, would require a supermajority of 308 out of 513 seats (60%) in the lower house. Historically, this has proven difficult, and it will be especially tricky for a president with no executive experience, little legislative record, and who denounces the use of pork-barrel spending.1 Otherwise, Congress can ultimately be cajoled into following Bolsonaro. As such, for the first time since Lula's first election (2002 to 2006), the Brazilian president is well-positioned to pursue his agenda. Bolsonaro will likely initiate some easy supply-side policies like cutting corporate taxes and red tape for businesses. Besides, business sentiment could surge due to the emergence of a business-friendly government. Hence, Bolsonaro has some short-term, easy "boosters" before the long-term challenges resurface. Long-term constraints uncertain: Despite the above, the pace of reforms will be slow given that Bolsonaro is, in the end, a populist who will want to maintain power above all. We continue to doubt Bolsonaro's willingness and ability to pursue social security reforms. We suspect that the vast majority of his voters chose to cast their ballot due to his law-and-order agenda that included a focus on battling crime and corruption. His economic advisor, Paulo Guedes, spent more time touting his reformist credentials in foreign financial publications than on the campaign trail. As such, it is difficult to conclude that Bolsonaro actually has a strong mandate for painful pension reforms. Polls ahead of the election suggest that only 4% of the public wants pension reforms (Chart I-3). Chart I-3Brazil's Population Is Not Open To Fiscal Austerity Chart I-4The J-Curve Of Structural Reform That said, we are open-minded and willing to be proved wrong. If Bolsonaro supports very dramatic reforms in his first 12 months in office, when his political capital is strongest, he could pull through despite the likely opposition from the median voter. As our J-Curve Of Structural Reform suggests, Bolsonaro can survive the "danger zone" if he pushes ahead with painful reforms right away (Chart I-4). He will start with sufficient political capital to do so. For long-term investors, the chief question is this: Is Bolsonaro a Brazilian Ronald Reagan or merely a Brazilian Rodrigo Duterte? Judging from everything he himself - not his advisors - has said in the past and on the campaign trail, we would bet on the latter. ...But The Same Economic Problems Brazil is getting a new government, but the macro economic challenges remain the same. Namely, ballooning public debt, still high interest rates and an unsustainable pension system (Chart I-5). As discussed above, it is not evident that Bolsonaro will strive to enact major cuts in the social security system that would be very unpopular. Apart from pensions and privatization, other choices to tackle the unsustainable public debt dynamics include reducing interest rates and boosting nominal growth (Chart I-6). Bolsonaro's economic team has repeatedly discussed the need to reduce high interest rates. Chart I-5Much Needed Pension Reform! Chart I-6Brazil's Macro Distortions   Chart I-7The Real Is Still At Risk Of Depreciation Rapid and large interest rate cuts by the central bank will help to service the public debt given that 96% of public debt is in local currency. Yet, lower interest rates could put pressure on the currency to depreciate - the interest rate differential between Brazil and the U.S. is at all-time lows (Chart I-7). Meanwhile, a weaker currency is needed to increase nominal growth. Notably, extremely low inflation and weak nominal growth have worsened the nation's public debt dynamics in recent years. Overall, lower policy rates and currency devaluation are required to reflate Brazil out of a public debt trap. If the exchange rate stabilizes in the short run as foreign investors come back to Brazil, the central bank will reduce interest rates considerably. Lower borrowing costs in combination with a sharp rise in business confidence and existing pent-up investment demand will propel capital spending, employment and overall growth. In short, these are necessary conditions for Brazilian markets to outperform their EM peers, i.e., for relative outperformance. As to absolute performance, it also depends on the outlook for global markets. In a complete global risk-off mode (the odds of which are considerable at the moment) - in which EM currencies and risk assets continue rioting and U.S. share prices drop - it will be difficult for Brazilian risk assets to rally meaningfully. That said, they will still outperform their EM peers. In the long run, pursuing policies of lower-than-needed interest rates and, hence, of chronic currency depreciation appears to be more palatable to Bolsonaro's populist credentials than difficult structural reforms. Therefore, investors who look to commit long-term capital to Brazil should mind the exchange rate. Populist policies favoring nominal growth in the long run lead to chronic currency depreciation. Bottom Line: Bolsonaro's election and his initial policies will be cheered by markets and will help Brazilian markets to outperform their EM peers for now. However, Bolsonaro is a populist and in the long term will choose economic policies that favor high nominal growth and, thereby, warrant chronic currency depreciation. Investment Recommendations Chart I-8Overweight Brazilian Assets Relative To EM In terms of market recommendations, we have the following: For EM dedicated portfolios, we recommend upgrading Brazil to overweight within the equity, credit, and local currency bonds universes (Chart I-8). BCA's Emerging Market Strategy service is taking a 14% profit on its structural short BRL versus USD position. Also, we are closing the short BRLMXN and short BRLARS trades with a 12% gain and a 5.7% loss, respectively. We also recommend closing the short Brazilian bank stocks trade initiated on May 16, 2018, as its return is now flat due to the recent rebound over the past few days. Absolute performance of Brazilian risk assets is contingent on global financial markets sentiment and at the moment odds of global risk off are considerable. This could cap the rally in Brazilian risk assets for now. Long-term investors should realize that timing Brazilian markets in general, and the exchange rate in particular, will be critical to protect gains. We believe that the path of least resistance for Bolsonaro and his team will be to depreciate the currency and engender nominal GDP growth in order to inflate away the country's public debt. This is a smart strategy for which they have a political mandate. But it will be a death-knell for foreign investors with major positions in the country.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 In late 1998, for instance, even President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999.  

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

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

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

Special Report

Highlights European and Japanese wages have firmed significantly, suggesting upside to inflation in these economies. However, the gain in European wages will soon reverse, as the slowdown in global trade percolates through the European economy. The ECB will not raise rates sooner or faster than currently discounted in markets, and German Bunds remain attractive in currency hedged terms. Japanese wage growth seems more sustainable but Japanese inflation expectations remain anchored to the downside, and Japan will suffer from a fiscal shock when the consumption tax is increased next October. Japan's YCC policy will remain in place for at least another 18 months, and fixed-income investors should continue to overweight JGBs in currency-hedged fixed income portfolios. Feature The pick-up in wage growth this summer in the euro area and Japan has been an interesting development. It raises the risk that inflation in these two economies is about to hit an inflection point. Since growth has returned to these two regions, if inflation were to join the party, the European Central Bank and the Bank of Japan would finally be able to follow in the Federal Reserve's footsteps and begin increasing rates sooner rather than later. This week we explore whether or not inflationary pressures are building in Europe and Japan, and whether or not the expected policy path of the ECB and the BoJ needs to be re-assessed. While cyclical pressures are growing, clouds above the global economy - the EM space in particular - suggest that the policy path currently anticipated by money markets is just right, and no glaring mis-pricings are evident. Euro Area: A Dawn Is Not A Sunrise The Necessary Condition For Inflation Is Here... There is no denying that we have seen massive improvements in the euro area economy. In fact, we would argue that the euro area has finally hit a stage where the necessary condition for a re-emergence of inflation has been met: Economic slack has vanished. There seems to be little spare capacity in the aggregate euro area economy. Today the OECD measure for the output gap stands at +0.5% of GDP. Additionally, a basic approach comparing the level of industrial production to a simple statistical filter further confirms this assessment, showing that production stands 2% above trend (Chart 1). The capacity utilization measure published by the European Commission goes one step further, showing that utilization is at its highest level since 2008. This represents a very significant change from the days of 2011-2015, when capacity utilization stood below the average that prevailed from the time of the euro's introduction (Chart 2). Chart 1No More Slack In Europe Chart 2Capacity Utilization Is At Previous Cycle Peaks The labor market has been a particular source of concern for euro area watchers. After all, how can an economy generate any domestic inflationary pressures if wages remain depressed? On that front too, there is plenty to rejoice about. The gap between the euro area's unemployment rate and the OECD's estimate of the non-accelerating rate of unemployment (NAIRU) has nearly fully disappeared. Historically, such an occurrence has been associated with a rise in European core inflation (Chart 3). In fact, the ECB's labor underutilization survey is now at its lowest level in 10 years. Moreover, in its various business conditions surveys, the European Commission asks firms whether labor is a factor limiting production. With the exception of Italy, the number of firms reporting that labor shortages are a problem in most of the major economies stands at or near record highs (Chart 4). This confirms the simple impression provided by the gap between the unemployment rate and NAIRU that the labor market is beginning to create generalized inflationary and wage pressures. Chart 3Diminishing Labor Market Slack Leads##br## To Growing Inflationary Pressures Chart 4Labor Shortages In ##br##The Euro Area ...But The Sufficient Conditions Remain Murkier While the tight labor market suggests that wages have cyclical upside, is it even true that higher wages do lead to higher inflation in the euro area? The answer is yes. Chart 5 shows that euro area wages tend to lead core CPI by approximately three quarters, with an explanatory power of nearly 87%. This makes sense. Higher wages increase the cost of production for businesses, which results in cost-push inflation. This is even more true if wages rise in real terms, which boosts household's income and supports consumption. Thus, it is likely that the recent spike in wages will lead to higher core inflation. Despite this positive backdrop, some key cyclical worries remain. First, our CPI diffusion index for the euro area, measuring the breadth of inflation increases within the subcomponents of the CPI, is in free-fall. Historically, this has been a worrying sign for core inflation, and for both nominal and real wages (Chart 6). Chart 5In Europe, Wages ##br##Lead Core CPI Chart 6But CPI Diffusion Index Suggests Real Wages ##br##And Core CPI Could Hit A Speed Bump The bigger risk originates from outside the euro area. We have shown in the past that EM shocks can have a disproportionate impact on European economic activity.1 This link seems to run deeper than we had originally realized. As Chart 7 shows, euro area nominal and real wages tend to follow the trend in European exports to EM and China. The logical conclusion is that export shocks end up affecting the whole economy by depressing profits, capex and the willingness of firms to provide wage increases to their employees. This also ends up reverberating into consumption as both nominal and, more importantly, real wages suffer. Today, weakening exports to EM and China suggest that European wages may soon roll over. This would take the wind out of price inflation as well, since wages lead core CPI by roughly three quarters. BCA's Foreign Exchange Strategy service as well as our Emerging Market Strategy sister publication have already highlighted that EM economies are likely to slow further in the coming quarters as China works to de-lever - a process which has already begun (Chart 8).2 Thus, the negative impact of EM on European growth and wages is likely only to grow over the coming quarters. The euro area leading economic indicator (LEI) has already picked up on these dynamics. The deterioration in the LEI suggests that real wages are likely to soon suffer, which will further dent euro area consumption and weigh on core inflation (Chart 9). Chart 7Exports To EM Are The Culprit##br## Behind This Speed Bump Chart 8Limited Upside Ahead##br## In Chinese Growth Chart 9Euro Area LEI Confirms##br## The Message From Exports Adding up those various message we conclude that while we could soon see some upside in inflation via a pass-through of the recent pick-up in wages, the upside is likely to prove transitory as the euro area economy will soon feel the deflationary impact of the slowdown in EM economic activity. What Will The ECB Do? The ECB will end its asset purchase program at the end of this year. Money markets are currently pricing in a full 25-basis-point hike in interest rates by March 2020. However, various formulations of the Taylor Rule suggest that euro area interest rates should already be higher than they currently are (Chart 10). What are interest rates likely to really do in relation to this date? Despite these hawkish Taylor Rule estimates, we think the ECB is likely to wait and see. As we highlighted above, the slack in the euro area economy is dissipating, and therefore inflationary pressures are bound to build up. However, the slowdown in EM that is reverberating through global trade will weigh on inflation over the coming six months. Additionally, we need to monitor developments in shadow policy rates.3 After the Fed began tapering its asset purchases in 2014, the U.S. shadow rate increased by roughly 300 basis points. While the actual fed funds rate was not raised until the end of 2015, the implied tightening from the rise in the shadow rate was enough to cause both U.S. and non-U.S. growth to slow sharply in 2015. Since bottoming in November 2016, the ECB's shadow rate has increased by 450 basis points. Even if European monetary conditions remain accommodative, this is a large and sudden shock to absorb - one that goes a long way in explaining the sudden contraction in the euro area credit impulse (Chart 11). Chart 10Does Europe Really Need Higher Rates? Chart 11Large Tightening In Euro Area Shadow Rate Ultimately, while the reduction in the euro area economic slack is real, the aforementioned dynamics are worrisome. Hence, we do not think that the ECB will want to prematurely kill off the recovery. Memories of the policy mistake of 2010, when the ECB raised rates in a too-weak economy, are still very much alive on the ECB's Governing Council. This means that a small first hike of less than 25 basis points in late 2019 or early 2020 seems appropriate, as there should be more convincing evidence by then that the economy can tolerate higher interest rates. Hence, there does not seem to currently be any mis-pricing in the European interest rate curve since investors are correctly pricing in a full 25-basis points of hikes from the ECB by March 2020. Investment Implications We continue to recommend U.S. investors hold European bonds while hedging the currency exposure back into U.S. dollar. A hedged 10-year Bund currently yields 3.66%, compared to 3.2% for a 10-year Treasury note. The picture above does not suggest that Bund yields will have enough upside to generate the capital losses needed to offset this yield pick-up, especially as Treasury prices suffer greater potential downside. This also means that once hedging costs are taken into account, European fixed-income investors are better off staying at home than playing in the U.S. government bond market. The impact for EUR/USD is more complex. The U.S. Overnight Index Swap (OIS) curve is currently pricing in roughly three rate hikes by the Fed over the next 12 months. BCA think that there could be even more U.S. rate hikes as the Fed continues to follow a 25 basis-points-per-quarter pace. Thus, we do not see the spread between U.S. and euro area interest rates narrowing in a more bullish direction for the euro Moreover, currencies trade on more than just interest rate differentials. The dollar has historically responded favorably to slowing EM growth. Moreover, as we highlighted three weeks ago, since the U.S. balance of payments is currently in surplus, this means that the U.S. is sucking in liquidity from the rest of the world.4 This is another way of saying that the world is buying more dollars than the U.S. is supplying. As a result, the dollar could continue to experience upside versus the euro over this period from factors beyond simple rate differentials. Bottom Line: The euro area economic slack has greatly dissipated and the medium term outlook for inflation is improving. Moreover, the recent pick-up in euro area wages suggest that core CPI could also pick up in the coming months. However, this increase in inflation is likely to prove temporary. Before inflation can increase durably, Europe will first have to digest the deflationary impact of slowing EM economies and global trade. This means that the ECB is likely to proceed with policy normalization very cautiously. The current pricing of 25 basis points of hikes by March 2020 is sensible. Hence, investors should continue to overweight Bunds hedged back into dollars in global fixed income portfolios. Moreover, EUR/USD could experience additional weaknesses on a 12-month basis. Japan: Fragile Progress, But Not Enough This past June, Japanese wage growth hit rates not seen in 21 years. This is enough to begin wondering if Japan is finally escaping its two-decades-long deflationary trap. After all, as Chart 12 shows, Japanese wages are a slow but nonetheless leading indicator of core inflation. Giving even more comfort to forecasts of higher Japanese inflation is the fact that, after falling continuously from the bubble peak in the early 1990s until Q1 2017, Japanese land prices have been slowly but surely increasing. Inflationary pressures in Japan are building up because the economy is at full employment. According to the BoJ, the output gap stands at +1.9% and has been positive for two years. The unemployment rate is at a stunningly low level of 2.4%, and the active job opening-to-applicant ratio stands at a four-decade high. The implications of this backdrop are evident. Chart 13 shows the demand/supply condition component of the Tankan survey of Japanese businesses, both in the manufacturing and non-manufacturing sectors. It has historically been a good explanatory variable for wage developments in Japan, and currently points to additional strength. Chart 12Rising Japanese Wages Should Boost Core Inflation Chart 13Capacity Pressures Are Lifting Japanese Wages Despite these positive developments, there remain some nagging worries. For one, the pick-up in wages seems strange in an economy where total hours worked are not rising (Chart 14). Moreover, Japanese households are currently increasing their savings ratio, which means that while they might be earning more, they are keeping this money in their bank accounts rather than spending it (Chart 14, bottom panel). As a result, there has been a limited pass-through of the recent wage acceleration into higher consumption. Additionally, like in Europe, the Japanese economy is at risk from foreign shocks. While the domestic economy seems robust, foreign machinery orders have been weakening. Industrial production has followed this path, decelerating sharply (Chart 15). Historically, Japanese inflation is very sensitive to the level of broader economic activity, so this weakening trend in industrial activity points to limited upside for overall inflation. Chart 14Weird Dynamics In Japan Chart 15Japan: The Domestic Front Is Healthy, The Foreign One Is Not The biggest problem faced by the BoJ, however, remains the weakness in inflation expectations. In the eyes of the Japanese central bank, the reason why Japanese realized inflation and wage growth have remained tepid is because decades of low inflation have created embedded expectations among the Japanese to not expect rising prices. Today, Japanese inflation expectations are once again weakening, a common occurrence when global growth slows (Chart 16). Additionally, Japan could hit a fiscal cliff of sorts next year. In October 2019, the consumption tax will increase from 8% to 10%. The last such increase - a three-percentage point hike in 2014 - caused a major slowdown in economic activity that had a deep deflationary impact. While the increase this time around is smaller and the Japanese economy is stronger than in 2014-2015, it remains to be seen how the country handles the shock of a fiscal tightening via a higher sales tax, especially if exports to EM remain on their downward path. The BoJ is likely to be very cognizant of this risk. Currently, the low level of inflation means that the real BoJ policy rate is in line with that of the U.S., a much stronger economy (Chart 17, top panel). Since Japan still faces a fiscal cliff next year and inflation expectations have not yet been unmoored to the upside, the current increase in wages is not enough to push the BoJ to abandon its Yield Curve Control (YCC) policy. What about QQE? The low shadow rate means that the BoJ does not need to buy assets anymore (Chart 17, bottom panel). Yet, the problem for Japan is that QQE possesses a strong signaling component. Ending this program is likely to cause markets to price in the end of YCC, which would drive nominal rates higher and thus result in both higher real rates and a significant tightening in monetary policy. As a result, we expect QQE to remain in place so that YCC will stay credible. However, the program is likely to have a slower pace of buying than before and will be too small to fully absorb the new issuances of JGBs by the MoF (Chart 18). Chart 16The BoJ's ##br##Number 1 Problem Chart 17The Signaling Effect Of QQE Is##br## Still Needed Because Of YCC... Chart 18...But QQE Doesn't Need To Be ##br##Quite As Large Anymore In terms of signposts that would signal to us to begin betting on an end to YCC, we continue to target three things that must ALL happen in unison, highlighted by BCA's Chief Global Fixed Income Strategist, Rob Robis, in February:5 USD/JPY rises at least to the 115-120 range; Japanese core CPI and nominal wage inflation both rise above 1.5%; 10-year JGB yields reaching an overvalued extreme, based on a model that includes potential GDP, BoJ purchases and the level of 10-year Treasury yields. So far, none of these conditions has been met. In fact, the slowdown in global trade and EM activity could even threaten the current improvement witnessed in wages. As a result, we expect all three of these developments to only happen in 2020, leaving Japanese yields with very limited upside. Investment Implications Japanese fixed-income investors continue to be subsidized to remain at home and avoid U.S. Treasuries. Because short rates in Japan are so low, the yield on 10-year U.S. Treasuries hedged into yen yield is 0.05%, less than the 0.16% yield on 10-year JGBs. At the same time, U.S. fixed income investors are incentivized to buy JGBs and hedge the currency exposure into dollars. Additionally, with the BoJ unlikely to abandon its YCC program for potentially two more years, JGBs with up to 10-year maturities are unlikely to suffer capital losses. Largely for this reason, BCA's Global Fixed Income Strategy's recommended model bond portfolio, maintains a large overweight position in JGBs, but only for maturities less than 10 years as the BoJ's YCC program is not focused on yields beyond the 10-year point. Regarding the yen, the outlooks is treacherous. On one hand, a strong USD implies a weaker yen. So do higher 10-year Treasury yields, especially if JGB yields possess little upside. On the other hand, weakness in the EM space tends to result in a stronger yen as carry trades get unwound. Due to these bifurcated risks, we do not recommend buying the yen against the dollar. However, we think that at current levels the yen remains an attractive play against the euro and against the Australian dollar, especially on a six- to nine-month basis. Bottom Line: Japanese wages have enjoyed significant upside, but Japanese inflation expectations remain moribund. Moreover, Japan is likely to experience a negative fiscal shock next year as the consumption tax will once again be increased. These two risks, in addition with slowing global growth, mean that the BoJ is unlikely to abandon YCC until well into 2020. As a result, investors should continue to overweight JGBs with maturities of less than 10-years hedged back into U.S. dollars in a global fixed income portfolio. USD/JPY should enjoy further upside on a 12-month basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "ECB: All About China", dated April 7, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com and Emerging Markets Strategy Special Report, titled "Deciphering Global Trade Linkages", dated September 27, 2018, available at ems.bcaresearch.com 3 The shadow rate is a measure of the impact of the various unorthodox policy initiatives implemented by central banks in the wake of the great financial crisis. It tries to express the effect of those measures in terms of the implied levels of policy rates that would have needed to prevail for the economy to generate the same performance if asset purchases had not been implemented. 4 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergences Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 5 Please see Global Fixed Income Strategy Special Report, titled "What Would It Take For The Bank Of Japan To Raise Its Yield Target", dated February 13, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades