Fixed Income

Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook. This year, Mr. X introduced us to his daughter, who we shall identify as Ms. X. She has many years of experience as a portfolio manager, initially in a wealth management firm, and subsequently in two major hedge funds. In 2017, she joined her father to help him run the family office portfolio. She took an active role in our recent discussion and this report is an edited transcript of our conversation. Mr. X: As always, it is a great pleasure to sit down with you to discuss the economic and investment outlook. And I am thrilled to bring my daughter to the meeting. She and I do not always agree on the market outlook and appropriate investment strategy, but even in her first year working with me she has added tremendous value to our decisions and performance. As you know, I have a very conservative bias in my approach and this means I sometimes miss out on opportunities. My daughter is more willing than me to take risks, so we make a good team. I am happy that our investment portfolio has performed well over the past year, but am puzzled by the high level of investor complacency. I can't understand why investors do not share my concerns about by sky-high valuations, a volatile geopolitical environment and the considerable potential for financial instability. Over the years, you have made me appreciate the power of easy money to create financial bubbles and also that market overshoots can last for a surprisingly long time. Thus, I am fully aware that we could easily have another year of strong gains, but were that to happen, I would worry about the potential for a sudden 1987-style crash. I remember that event well and it was an unpleasant experience. My inclination is to move right now to an underweight equity position. Ms. X: Let me add that I am delighted to finally attend the annual BCA meeting with my father. Over the years, he has talked to me at length about your discussions, making me very jealous that I was not there. He and I do frequently disagree about the outlook so it will be good to have BCA's independent and objective perspective. As my father noted, I do not always share his cautious bias. When I joined the family firm in early 2017, I persuaded him to raise our equity exposure and that was the right decision. I have been in the business long enough to know that it is dangerous to get more bullish as the market rises and I agree there probably is too much complacency. However, I do not see an early end to the conditions that are driving the bull market and I am inclined to stay overweight equities for a while longer. Thus, the big debate between us is whether or not we should now book profits from the past year's strong performance and move to an underweight stance in risk assets. Hopefully, this meeting will help us make the right decision. Chart 1An Impressive Bull Market BCA: First of all, we are delighted to see you both and look forward to getting to know Ms. X in the years to come. It is not a surprise that you are debating whether to cut exposure to risk assets because that question is on the mind of many of our clients. We share your surprise about complacency - investors have been seduced by the relentless upward drift of prices since early 2016. The global equity index has not suffered any setback above 2% during the past year, and that has to be close to a record (Chart 1). The conditions that have underpinned this remarkable performance are indeed still in place but we expect that to change during the coming year. Thus, if equity prices continue to rise, it would make sense to reduce exposure to risk assets to a neutral position over the next few months. A blow-off phase with a final spike in prices cannot be ruled out, but trying to catch those moves is a very high-risk strategy. We are not yet recommending underweight positions in risk assets, but if our economic and policy views pan out, we likely will shift in that direction in the second half of 2018. Ms. X: It seems that you are siding with my father in terms of wanting to scale back exposure to risk assets. That would be premature in my view and I look forward to discussing this in more detail. But first, I would be interested in reviewing your forecasts from last year. BCA: Of course. A year ago, our key conclusions were that: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time lags in implementing policy mean that the fiscal plans of President-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. The key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given President-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. The most important prediction that we got right was our view that conditions were ripe for an overshoot in equity prices. The MSCI all-country index has delivered an impressive total return of around 20% in dollar terms since the end of 2016, one of the best calendar year performances of the current cycle (Table 1). So it was good that your daughter persuaded you to keep a healthy equity exposure. It is all the more impressive that the market powered ahead in the face of all the concerns that you noted earlier. Our preference for European markets over the U.S. worked out well in common currency terms, but only because the dollar declined. Emerging markets did much better than we expected, with significant outperformance relative to their developed counterparts. Table 1Market Performance With regard to the overall economic environment, we were correct in forecasting a modest improvement in 2017 global economic activity and that growth would not fall short of the IMF's predictions for the first time in the current expansion. However, one big surprise, not only for us, but also for policymakers, was that inflation drifted lower in the major economies. Latest data show the core inflation rate for the G7 economies is running at only 1.4%, down from 1.6% at the end of 2016. We will return to this critical issue later as the trend in inflation outlook will be a key determinant of the market outlook for the coming year and beyond. Regionally, the Euro area and Japanese economies registered the biggest upside surprises relative to our forecast and those of the IMF (Table 2). That goes a long way to explaining why the U.S. dollar was weaker than we expected. In addition, the dollar was not helped by a market downgrading of the scale and timing of U.S. fiscal stimulus. Nonetheless, it is worth noting that the dollar has merely unwound the 2016 Trump rally and recently has shown some renewed strength. Table 2IMF Economic Forecasts A year ago, there were major concerns about potential political turmoil from important elections in Europe, the risk of U.S.-led trade wars and a credit bust-up in China. We downplayed these issues as near-term threats to the markets and that turned out to be appropriate. Nevertheless, there are many lingering risks to the outlook and market complacency is a much bigger concern now than it was a year ago. Mr. X: As you just noted, a key theme of your Outlook last year was "Shifting Regimes" such as the end of disinflation and fiscal conservatism, a retreat from globalization, and the start of a rebalancing in income shares away from profits toward labor. And of course, you talked about the End of the Debt Supercycle a few years ago. Do you still have confidence that these regime shifts are underway? BCA: Absolutely! These are all trends that we expect to play out over a number of years and thus can't be judged by short-term developments. There have been particularly important shifts in the policy environment. The 2007-09 economic and financial meltdown led central banks to fight deflation rather than inflation and we would not bet against them in this battle. Inflation has been lower than expected, but there has been a clear turning point. On fiscal policy, governments have largely given up on austerity against a background of a disappointingly slow economic recovery in recent years and rising populist pressures (Chart 2). The U.S. budget deficit could rise particularly sharply over the next few years. In the U.S., the relative income shares going to profits and labor have started to shift direction, but there is a long way to go. Finally, the same forces driving government to loosen fiscal purse strings have also undermined support for globalization with the U.S. even threatening to abandon NAFTA. The ratio of global trade to output has trended sideways for several years and is unlikely to turn higher any time soon. All these trends are part of our Regime Shift thesis. Chart 2Regime Shifts The remarkable macro backdrop of low inflation, easy money and healthy profits has been incredibly positive for financial markets in recent years. You would have to be an extreme optimist to believe that such an environment will persist. Our big concern for the coming year is that we are setting up for a collision between the markets and looming changes in economic policy. The Coming Collision Between Policy And The Markets BCA: As you mentioned earlier, we attach enormous importance to the role of easy money in supporting asset prices and it is hard to imagine that we could have had a more stimulative monetary environment than has existed in recent years. Central banks have been in panic mode since the 2007-09 downturn with an unprecedented period of negative real interest rates in the advanced economies, coupled with an extraordinary expansion of central bank balance sheets (Chart 3). Initially, the fear was for another Great Depression and as that threat receded, the focus switched to getting inflation back to the 2% target favored by most developed countries. In a post-Debt Supercycle world, negative real rates have failed to trigger the typical rebound in credit demand that was so characteristic of the pre-downturn era. Central banks have expanded base money in the form of bank reserves, but this has not translated into markedly faster growth in broad money or nominal GDP. This is highlighted by the collapse in money multipliers (the ratio of broad to base money) and in velocity (the ratio of GDP to broad money). This has been a double whammy: there is less broad money generated for each dollar of base money and less GDP for every dollar of broad money (Chart 4). Chart 3An Extraordinary Period Of Easy Money Chart 4Monetary Policy: Pushing On A String Historically, monetary policy acted primarily through the credit channel with lower rates making households and companies more willing to borrow, and lenders more willing to supply funds. In the post-Debt Supercycle world, the credit channel has become partly blocked, forcing policymakers to rely more on the other channels of monetary transmission, the main one being boosting asset prices. However, there is a limit to how far this can go because the end result is massively overvalued assets and building financial excesses. The Fed and many other central banks now realize that this strategy cannot be pushed much further. The economic recovery in the U.S. and other developed economies has been the weakest of the post-WWII period. But potential growth rates also have slowed which means that spare capacity has gradually been absorbed. According to the IMF, the U.S. output gap closed in 2015 having been as high as 2% of potential GDP in 2013. The IMF estimates that the economy was operating slightly above potential in 2017 with a further rise forecast in 2018 (Chart 5). According to IMF estimates, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018 (i.e. they will be operating above potential). This makes it hard to justify the maintenance of hyper-stimulative monetary policies. Chart 5No More Output Gaps The low U.S. inflation rate is giving the Fed the luxury of moving cautiously and that is keeping the markets buoyant. Indeed, the markets don't even believe the Fed will be able to raise rates as much they expect. The most recent FOMC projections show a median federal funds rate of 2.1% by the end of 2018 but the markets are discounting a move to only 1.8%. The markets probably have this wrong because inflation is likely to wake up from its slumber in the second half of the year. Ms. X: This is another area where my father and I disagree. I view the world as essentially deflationary. We all know that technological innovations have opened up competition in a lot of markets, driving down prices. Two obvious examples are Uber and Airbnb, but these are just the tip of the iceberg. Amazon's purchase of Whole Foods is another example of how increased competitive pressures will continue to sweep through previously relatively stable industries. And such changes have an important impact on employee psychology and thus bargaining power. These days, people are glad to just keep their jobs and this means companies hold the upper hand when it comes to wage negotiations. So I don't see a pickup in inflation being a threat to the markets any time soon. Mr. X: I have a different perspective. First of all, I do not even believe the official inflation data because most of the things I buy have risen a lot in price over the past couple of years. Secondly, given the extremely stimulative stance of monetary policy in recent years, a pickup in inflation would not surprise me at all. So I am sympathetic to the BCA view. But, even if the data is correct, why have inflation forecasts proved so wrong and what underpins your view that it will increase in the coming year? BCA: There is an interesting disconnect between the official data and the inflation views of many consumers and economic/statistics experts. According to the Conference Board, U.S. consumers' one-year ahead inflation expectations have persistently exceeded the published data and the latest reading is close to 5% (Chart 6). That ties in with your perception. Consumer surveys by the New York Fed and University of Michigan have year-ahead inflation expectations at a more reasonable 2.5%. At the same time, many "experts" believe the official data is overstated because it fails to take enough account of technological changes and new lower-priced goods and services. The markets also have a moderately optimistic view with the five-year CPI swap rate at 2%. This is optimistic because it is consistent with inflation below the Fed's 2% target, if one allows for an inflation risk premium built in to the swap price. We are prepared to take the inflation data broadly at face value. Low inflation is consistent with an ongoing tough competitive environment in most sectors, boosted by the disruptive impact of technological changes that Ms. X described. The inflation rate for core goods (ex-food and energy) has been in negative territory for several years while that for services ex-shelter is at the low end of its historical range (Chart 7). Chart 6Differing Perspectives Of Inflation Chart 7Not Much Inflation Here There is no simple explanation of why inflation has fallen short of forecasts. Economic theory assumes that price pressures build as an economy moves closer to full employment and the U.S. is at that point. This raises several possibilities: There is more slack in the economy than suggested by the low unemployment rate. The lags are unusually long in the current cycle. Technological disruption is having a greater impact than expected. The link between economic slack and inflationary pressures is typically captured by the Phillips Curve which shows the relationship between the unemployment rate and inflation. In the U.S., the current unemployment rate of 4.1% is believed to be very close to a full-employment level. Yet, inflation recently has trended lower and while wage growth is in an uptrend, it has remained softer than expected (Chart 8). Chart 8Inflationary Pressures Are Turning We agree with Ms. X that employee bargaining power has been undermined over the years by globalization and technological change and by the impact of the 2007-09 economic downturn. That would certainly explain a weakened relationship between the unemployment rate and wage growth, but does not completely negate the theory. The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. As far as the impact of technology is concerned, there is no doubt that innovations like Uber and Airbnb are deflationary. However, our analysis suggests that the growth in online spending has not had a major impact on the inflation numbers. E-commerce still represents a small fraction of total U.S. consumer spending, depressing overall consumer inflation by only 0.1 to 0.2 percentage points. The deceleration of inflation since the global financial crisis has been in areas largely unaffected by online sales, such as energy and rent. Moreover, today's creative destruction in the retail sector is no more deflationary than the earlier shift to 'big box' stores. We are not looking for a dramatic acceleration in either wage growth or inflation - just enough to convince the Fed that it needs to carry on with its plan to raise interest rates. And the pressure to do this will increase if the Administration is able to deliver on its planned tax cuts. Ms. X: You make it sound as if cutting taxes would be a bad thing. Surely the U.S. would benefit from the Administration's tax plan? A reduction in the corporate tax rate would be very bullish for equities. BCA: The U.S. tax system is desperately in need of reform via eliminating loopholes and distortions and using the savings to lower marginal rates. That would make it more efficient and hopefully boost the supply side of the economy without undermining revenues. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. Importantly, there is not a strong case for personal tax cuts given that a married worker on the average wage and with two children paid an average income tax rate of only 14% in 2016, according to OECD calculations. There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. The combination of easier fiscal policy and Fed rate hikes will be bullish for the dollar and this will contribute to tighter overall financial conditions. That is why we see a coming collision between economic policy and the markets. The narrative for the so-called Trump rally in markets was based on the assumption that the Administration's platform of increased spending, tax cuts and reduced regulations would be bullish for the economy and thus risk assets. That was always a misplaced notion. The perfect environment for markets has been moderate economic growth, low inflation and easy money. The Trump agenda would be appropriate for an economy that had a lot of spare capacity and needed a big boost in demand. It is less suited for an economy with little spare capacity. Reduced regulations and lower corporate tax rates are good for the supply side of the economy and could boost the potential growth rate. However, if a key move is large personal tax cuts then the boost to demand will dominate. Mr. X: It seems that you are making the case for a serious policy error in the U.S. in the coming year - both on fiscal and monetary policy. I can't argue against that because everything that has happened over the past few years tells me that policymakers don't have a good grip on either the economy or the implications of their actions. I never believed that printing money and creating financial bubbles was a sensible approach to an over-indebted economy. I always expected it to end badly. BCA: Major tightening cycles frequently end in recession because monetary policy is a very blunt tool. Central banks would like to raise rates by just enough to cool things down but that is hard to achieve. The problem with fiscal policy is that implementation lags mean that it often is pro-cyclical. In other words, there is pressure for fiscal stimulus in a downturn, but by the time legislation is passed, the economy typically has already recovered and does not really need a big fiscal boost. And that certainly applies to the current environment. The other area of potential policy error is on trade. Having already pulled the U.S. out of the Trans-Pacific Partnership, the Trump Administration is taking a hardline attitude toward a renegotiation of NAFTA. This could even end up with the deal being scrapped and that would add another element of risk to the North American economies. Ms. X: Your scenario assumes that the Fed will be quite hawkish. However, everything I have read about Jerome Powell, the new Fed chair, suggests that he will err on the side of caution when it comes to raising rates. So monetary policy may not collide with markets at all over the coming year. BCA: It is certainly true that Powell does not have any particular bias when it comes to the conduct of monetary policy. That would not have been the case if either John Taylor or Kevin Warsh had been given the job - they both have a hawkish bias. Powell is not an economist so will likely follow a middle path and be heavily influenced by the Fed's staff forecasts and by the opinions of other FOMC members. There are still several vacancies on the Fed's Board so much will depend on who is appointed to those positions. The latest FOMC forecasts are for growth and inflation of only 2% in 2018 and these numbers seem too low. Meanwhile, the prediction that unemployment will still be at 4.1% at end-2018 is too high. We expect projections of growth and inflation to be revised up and unemployment to be revised down. That will embolden the Fed to keep raising rates. So, even with Powell at the helm, monetary policy is set to get tighter than the market currently expects. Ms. X: So far, we have talked mainly about the U.S. What about other central banks? I can't believe that inflation will be much of a problem in the euro area or in Japan any time soon. Does that not mean that the overall global monetary environment will stay favorable for risk assets? BCA: The Fed is at the leading edge of the shift away from extreme monetary ease by hiking interest rates and starting the process of balance sheet reduction. But the Bank of Canada also has raised rates and the ECB has announced that it will cut its asset purchases in half beginning January 2018, as a first step in normalizing policy. Even the Bank of England has raised rates despite Brexit-related downside risks for the economy. The BoJ will keep an accommodative stance for the foreseeable future. You are correct that financial conditions will be tightening more in the U.S. than in other developed economies. Moreover, equity valuations are more stretched in the U.S. than elsewhere leaving that market especially vulnerable. Yet, market correlations are such that any sell-off in U.S. risk assets is likely to become a global affair. Another key issue relates to the potential for financial shocks. Long periods of extreme monetary ease always fuel excesses and sometimes these remain hidden until they blow up. We know that companies have taken on a lot of debt, largely to fund financial transactions such as share buybacks and merger and acquisitions activity. That is unlikely to be the direct cause of a financial accident but might well become a problem in the next downturn. It typically is increased leverage within the financial sector itself that poses the greatest risk and that is very opaque. The banking system is much better capitalized than before the 2007-09 downturn so the risks lie elsewhere. As would be expected, margin debt has climbed higher with the equity market, and is at a historically high level relative to market capitalization (Chart 9). We don't have good data on the degree of leverage among non-bank financial institutions such as hedge funds but that is where leverage surprises are likely to occur. And the level of interest rates that causes financial stress is almost certainly to be a lot lower than in the past. Chart 9Financial Leverage Has Risen Mr. X: That is the perfect lead-in to my perennial concern - the high level of debt in the major economies. I realize high debt levels are not a problem when interest rates are close to zero, but that will change if your view on the Fed is correct. Ms. X: I would just add that this is one area where I share my father's concerns, but with an important caveat. I wholeheartedly agree that high debt levels pose a threat to economic and financial stability, but I see this as a long-term issue. Even with rising interest rates, debt servicing costs will stay low for at least the next year. It seems to me that rates will have to rise a lot before debt levels in the major economies pose a serious threat to the system. Even if the Fed tightens policy in line with its plans, real short rates will still stay low by historical standards. This will not only keep debt financing manageable but will also sustain the search for yield and support equity prices. BCA: We would be disappointed if you both had not raised the issue of debt. Debt levels do indeed remain very elevated among advanced and emerging economies (Chart 10). The growth in private debt remains far below pre-crisis levels in the advanced countries, but this has been offset by the continued high level of government borrowing. As a result, the total debt-to-GDP ratio has stayed close to a peak. And both private and public debt ratios have climbed to new highs in the emerging economies, with China leading the charge. Chart 10ADebt Levels Remain Elevated Chart 10BDebt Levels Remain Elevated As we have discussed in the past, there is not an inconsistency between our End of Debt Supercycle thesis and the continued high levels of debt in most countries. As noted earlier, record-low interest rates have not triggered the kind of private credit resurgence that occurred in the pre-crisis period. For example, household borrowing has remained far below historical levels as a percent of income in the U.S., despite low borrowing costs (Chart 11). At the same time, it is not a surprise that debt-to-income ratios are high given the modest growth in nominal incomes in most countries. Chart 11Low Rates Have Not Triggered ##br##A Borrowing Surge In U.S. Debt growth is not benign everywhere. In the developed world, Canada's debt growth is worryingly high, both in the household and corporate sectors. As is also the case with Australia, Canada's overheated housing market has fueled rapid growth in mortgage debt. These are accidents waiting to happen when borrowing costs increase. In the emerging word, China has yet to see the end of its Debt Supercycle. Fortunately, with most banks under state control, the authorities should be able to contain any systemic risks, at least in the near run. With regard to timing, we agree that debt levels are not likely to pose an economic or financial problem in next year. It is right to point out that debt-servicing costs are very low by historical standards and it will take time for rising rates to have an impact given that a lot of debt is locked in at low rates. For example, in the U.S., the ratio of household debt-servicing to income and the non-financial business sector's ratio of interest payments to EBITD are at relatively benign levels (Chart 12). However, changes occur at the margin and the example of the Bernanke taper tantrum highlighted investor sensitivity to even modest changes in the monetary environment. You may well be right Ms. X that risk assets will continue to climb higher in the face of a tighter financial conditions. But given elevated valuations, we lean toward a cautious rather than aggressive approach to strategy. We would rather leave some money on the table than risk being caught in a sudden downdraft. Other investors, including yourself, might prefer to wait for clearer signals that a turning point is imminent. Returning to the issue of indebtedness, the end-game for high debt levels continues to be a topic of intense interest. There really are only three options: to grow out of it, to write it off, or to try and inflate it away. The first option obviously would be best - to have fast enough growth in real incomes that allowed debtors to start paying down their debt. Unfortunately, that is the least likely prospect given adverse demographic trends throughout the developed world and disappointing productivity growth (Chart 13). Chart 12Borrowing Costs Are Benign Chart 13It's Hard To Grow Out Of Debt ##br##With These Structural Headwinds Writing the debt off - i.e. defaulting - is a desperate measure that would be the very last resort after all other approaches had failed. In this case, we are talking mainly about government debt, because private debt always has to be written off when borrowers become bankrupt. Japan is the one developed country where government debt probably will be written off eventually. Given that the Bank of Japan owns around 45% of outstanding government debt, those holdings can be neutralized by converting them to perpetuals - securities that are never redeemed. If the first two options are not viable, then inflation becomes the preferred solution to over-indebtedness. To make a big impact, inflation would need to rise far above the 2% level currently favored by central banks, and it would have to stay elevated for quite some time. Central banks are not yet ready to allow such an environment, but that could change after the next economic downturn. Central banks have made it clear that they are prepared to pursue radical policies in order to prevent deflation. This sets the scene for increasingly aggressive actions after the next recession and the end result could be a period of significantly higher inflation. Mr. X: I don't disagree with that view which is why I always like to hold some physical gold in my portfolio. It is interesting that you are worried about a looming setback for risk assets because you are positive on the near-run economic outlook. That is contrary to the typical view that sees a decent economy as supporting higher equity prices. Let's spend a bit more time on your view of the economic outlook. Ms. X: Before we do that, I would just emphasize that it is far too early to worry about debt end games and the potential for sharply rising inflation. I don't disagree that monetary policy could be forced to embrace massive reflation during the next downturn and perhaps that will make me change my view of the inflation outlook. But the sequencing is important because we would first have to deal with a recession that could be a very deflationary episode. And before the next recession we could have period of continued decent growth, which would be positive for risk assets. So I agree that the near-term view of the economic outlook is important. The Economic Outlook BCA: This recovery cycle has been characterized by a series of shocks and headwinds that constrained growth in various regions. In no particular order, these included fiscal austerity, the euro crisis, a brief U.S. government shutdown, the Japanese earthquake, and a spike in oil prices above $100. As we discussed a year ago, in the absence of any new shocks, we expected global growth to improve and that is what occurred in 2017. A broad range of indicators shows that activity has picked up steam in most areas. Purchasing managers' indexes are in an uptrend, business and consumer confidence are at cyclical highs and leading indicators have turned up (Chart 14). This is hardly a surprise given easy monetary conditions and a more relaxed fiscal stance almost everywhere. Chart 14Global Activity On An Uptrend The outlook for 2018 is positive and the IMF's projections for growth is probably too low (see Table 2). So, for the second year in a row, the next set of updates due in the spring are likely to be revised up. Ms. X: Let's talk about the U.S. economy. You are concerned that tax cuts could contribute to overheating, tighter monetary policy and an eventual collision with the markets. But there are two alternative scenarios, both quite optimistic for risk assets. On the one hand, a cut in the corporate tax rate could trigger a further improvement in business confidence and thus acceleration in capital spending. This would boost the supply side of the economy and mean that faster growth need not lead to higher inflation. It would be the perfect world of a low inflation boom. At the other extreme, if political gridlock prevents any meaningful tax cuts, we will be left with the status quo of moderate growth and low inflation that has been very positive for markets during the past several years. Mr. X: You can always rely on my daughter to emphasize the potential for optimistic outcomes. I would suggest another entirely different scenario. The cycle is very mature and I fear it would not take much to tip the economy into recession, even if we get some tax relief. So I am more concerned with near-term downside risks to the U.S. economy. A recession in the coming year would be catastrophic for the stock market in my view. BCA: Before we get to the outlook, let's agree on where we are right now. As we already noted, the U.S. economy currently is operating very close to its potential level. The Congressional Budget Office estimates potential growth to be only 1.6% a year at present, which explains why the unemployment rate has dropped even though growth has averaged a modest 2% pace in recent years. The consumer sector has generally been a source of stability with real spending growing at a 2¾% pace over the past several years (Chart 15). And, encouragingly, business investment has recently picked up from its earlier disappointing level. On the negative side, the recovery in housing has lost steam and government spending has been a source of drag. Looking ahead, the pattern of growth may change a bit. With regard to consumer spending, the pace of employment growth is more likely to slow than accelerate given the tight market and growing lack of available skilled employees. According to the National Federation of Independent Business survey, 88% of small companies hiring or trying to hire reported "few or no qualified applicants for the positions they were trying to fill". Companies in manufacturing and construction say that the difficulty in finding qualified workers is their single biggest problem, beating taxes and regulations. In addition, we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 16). On the other hand, wage growth should continue to firm and there is the prospect of tax cuts. Overall, this suggests that consumer spending should continue to grow by at least a 2% pace in 2018. Chart 15Trends In U.S. Growth Chart 16Personal Saving At A Recovery Low Survey data suggests that business investment spending should remain strong in the coming year, even without any additional boost from corporate tax cuts. Meanwhile, rebuilding and renovations in the wake of Hurricanes Harvey and Irma should provide a short-term boost to housing investment and a more lasting improvement will occur if the millennial generation finally moves out of their parents' basements. On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 17). And although housing affordability is down from its peak, it remains at an attractive level from a historical perspective. Chart 17A Weak Housing Recovery Last, but not least, government spending will face countervailing forces. The Administration plans to increase spending on defense and infrastructure but there could be some offsetting cutbacks in other areas. Overall, government spending should make a positive contribution to 2018 after being a drag in 2017. Putting all this together, the U.S. economy should manage to sustain a growth rate of around 2.5% in 2018, putting GDP further above its potential level. And it could rise above that if tax cuts are at the higher end of the range. You suggested three alternative scenarios to our base case: a supply-side boom, continued moderate growth and a near-term recession. A supply-side revival that leads to strong growth and continued low inflation would be extremely bullish, but we are skeptical about that possibility. The revival in capital spending is good news, but this will take time to feed into faster productivity growth. Overall, any tax cuts will have a greater impact on demand than supply, putting even greater pressure on an already tight labor market. The second scenario of a continuation of the recent status quo is more possible, especially if we end up with a very watered-down tax package. However, growth would actually have to drop below 2% in order to prevent GDP from rising above potential. We will closely monitor leading indicators for signs that growth is about to lose momentum. The bearish scenario of a near-term recession cannot be completely discounted, but there currently is no compelling evidence of such a development. Recessions can arrive with little warning if there is an unanticipated shock, but that is rare. Historically, a flat or inverted yield curve has provided a warning sign ahead of most recessions and the curve currently is still positively sloped (Chart 18). Another leading indicator is when cyclical spending1 falls as a share of GDP, reflecting the increased sensitivity of those items to changes in financial conditions. Cyclical spending is still at a historically low level relative to GDP and we expect this to rise rather than fall over the coming quarters. While a near-term recession does not seem likely, the odds will change during the course of 2018. By late year, there is a good chance that the yield curve will be flat or inverted, giving a warning signal for a recession in 2019. Our base case view is for a U.S. recession to start in the second half of 2019, making the current expansion the longest on record. At this stage, it is too early to predict whether it would be a mild recession along the lines of 1990-91 and 2000-01 or a deeper downturn. Chart 18No Recession Signals For The U.S. ...Yet Mr. X: I hope that you are right that a U.S. recession is more than a year away. I am not entirely convinced but will keep an open mind, and my daughter will no doubt keep me fully informed of any positive trends. Ms. X: You can be sure of that. Although I lean toward the optimistic side on the U.S. economy, I have been rather surprised at how well the euro area economy has done in the past year. Latest data show that the euro area's real GDP increased by 2.5% in the year to 2017 Q3 compared to 2.3% for the U.S. Can that be sustained? BCA: The relative performance of the euro area economy has been even better if you allow for the fact that the region's population growth is 0.5% a year below that of the U.S. So the economic growth gap is even greater on a per capita basis. The euro area economy performed poorly during their sovereign debt crisis years of 2011-13, but the subsequent improvement has meant that the region's real per capita GDP has matched that of the U.S. over the past four years. And even Japan's GDP has not lagged much behind on a per capita basis (Chart 19). Chart 19No Clear Winner On Growth The recovery in the euro area has been broadly based but the big change was the end of a fiscal squeeze in the periphery countries. Between 2010 and 2013, fiscal drag (the change in the structural primary deficit) was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There was little fiscal tightening in the subsequent three years, allowing those economies to recover lost ground. Meanwhile, Germany's economy has continued to power ahead, benefiting from much easier financial conditions than the economy has warranted. That has been the inevitable consequence of a one size fits all monetary policy that has had to accommodate the weakest members of the region. The French and Italian economies have disappointed, but there are hopes that the new French government will pursue pro-growth policies. And Italy should also pick up given signs that it is finally starting to deal with its fragile banking system. Both Spain and Italy faced a sharp rise in non-performing bank loans during the great recession, but Italy lagged Spain in dealing with the problem (Chart 20). That goes a long way to explaining why the Italian economic recovery has been so poor relative to Spain. With Italian banks raising capital and writing off non-performing loans more aggressively, the Italian economy should start to improve, finally catching up with the rest of the region. Overall, the euro area economy should manage to sustain growth above the 2.1% forecast by the IMF for 2018. Overall financial conditions are likely to stay favorable for at least another year and we do not anticipate any major changes in fiscal policy. If, as we fear, the U.S. moves into recession in 2019, there will be negative fallout for Europe, largely via the impact on financial markets. However, in relative terms, the euro area should outperform the U.S. during the next downturn. Mr. X: A year ago, you said that Brexit posed downside risks for the U.K. economy. For a while, that seemed too pessimistic as the economy performed quite well, but recent data show things have taken a turn for the worse. How do you see things playing out with this issue? BCA: It was apparent a year ago that the U.K. government had no concrete plans to deal with Brexit and little has changed since then. The negotiations with the EU are not going particularly well and the odds of a "hard" exit have risen. This means withdrawing from the EU without any agreement on a new regime for trade, labor movements or financial transactions. A growing number of firms are taking the precaution of shifting some operations from the U.K. to other EU countries. As you noted, there are signs that Brexit is starting to undermine the U.K. economy. For example, London house prices have turned down and the leading economic index has softened (Chart 21). The poor performance of U.K. consumer service and real estate equities relative to those of Germany suggest investors are becoming more wary of the U.K. outlook. Of course, a lot will depend on the nature of any deal between the U.K. and the EU and that remains a source of great uncertainty. Chart 20A Turning Point For Italian Banks? Chart 21U.K. Consumer Services Equities Are ##br##Underperforming Brexit Effects Show Up At the moment, there are no real grounds for optimism. The U.K. holds few cards in the bargaining process and the country's strong antipathy toward the free movement of people within the EU will be a big obstacle to an amicable separation agreement. Ms. X: I think the U.K. made the right decision to leave the EU and am more optimistic than you about the outlook. There may be some short-term disruption but the long-term outlook for the U.K. will be good once the country is freed from the stifling bureaucratic constraints of EU membership. The U.K. has a more dynamic economy than most EU members and it will be able to attract plenty of overseas capital if the government pursues appropriate policies toward taxes and regulations. It will take a few years to find out who is correct about this. In the meantime, given the uncertainties, I am inclined to have limited exposure to sterling and the U.K. equity market. Let's now talk about China, another country facing complex challenges. This is a topic where my father and I again have a lot of debates. As you might guess, I have been on the more optimistic side while he has sided with those who have feared a hard landing. And I know that similar debates have occurred in BCA. BCA: It is not a surprise that there are lots of debates about the China outlook. The country's impressive economic growth has been accompanied by an unprecedented build-up of debt and supply excesses in several sectors. The large imbalances would have led to a collapse by now in any other economy. However, China has benefited from the heavy state involvement in the economy and, in particular, the banking sector. The big question is whether the government has enough control over economic developments to avoid an economic and financial crisis. The good news is that China's government debt is relatively low, giving them the fiscal flexibility to write-off bad debts from zombie state-owned enterprises (SOEs). The problems of excessive leverage and over-capacity are particularly acute in SOEs that still comprise a large share of economic activity. The government is well aware of the need to reform SOEs and various measures have been announced, but progress has been relatively limited thus far. The IMF projects that the ratio of total non-financial debt to GDP will remain in an uptrend over the next several years, rising from 236% in 2016 to 298% by 2022 (Chart 22). Yet, growth is expected to slow only modestly over the period. Of course, one would not expect the IMF to build a crisis into their forecast. Some investors have been concerned that a peak in China's mini-cycle of the past two years may herald a return to the economic conditions that prevailed in 2015, when the industrial sector grew at a slower pace than during the acute phase of the global financial crisis. These conditions occurred due to the combination of excessively tight monetary conditions and weak global growth. While China's export growth may slow over the coming year, monetary policy remains accommodative. Monetary conditions appear to have peaked early this year but are still considerably easier than in mid-2015. Shifts in the monetary conditions index have done a good job of leading economic activity and they paint a reasonably positive picture (Chart 23). The industrial sector has finally moved out of deflation, with producer prices rising 6.9% in the year ended October. This has been accompanied by a solid revival in profits. Chart 22China: Debt-Fueled Growth To Continue Chart 23China Leaves Deflation Behind On balance, we assume that the Chinese economy will be able to muddle through for the foreseeable future. President Xi Jinping has strengthened his grip on power and he will go to great lengths to ensure that his reign is not sullied with an economic crisis. The longer-term outlook will depend on how far the government goes with reforms and deleveraging and we are keeping an open mind at this point. In sum, for the moment, we are siding with Ms. X on this issue. Mr. X: I have been too bearish on China for the past several years, but I still worry about the downside risks given the massive imbalances and excesses. I can't think of any example of a country achieving a soft landing after such a massive rise in debt. I will give you and my daughter the benefit of the doubt, but am not totally convinced that you will be right. BCA has been cautious on emerging economies in general: has that changed? BCA: The emerging world went through a tough time in 2015-16 with median growth of only 2.6% for the 23 constituent countries of the MSCI EM index (Chart 24). This recovered to 3% in 2017 according to IMF estimates, but that is still far below the average 5% pace of the period 2000-07. Chart 24Emerging Economy Growth: ##br##The Boom Years Are Over It is always dangerous to generalize about the emerging world because the group comprises economies with very different characteristics and growth drivers. Two of the largest countries - Brazil and Russia - went through particularly bad downturns in the past couple of years and those economies are now in a modest recovery. In contrast, India has continued to grow at a healthy albeit slowing pace, while Korea and the ASEAN region have not suffered much of a slowdown. If, as seems likely, Chinese growth holds above a 6% pace over the next year, then those countries with strong links to China should do fine. And it also points to reasonably steady commodity prices, supporting resource-dependent economies. Longer-run, there are reasons to be cautious about many emerging economies, particularly if the U.S. goes into recession 2019, as we fear. That would be associated with renewed weakness in commodity prices, and capital flight from those economies with high external debt such as Turkey and South Africa. As we stated a year ago, the heady days of emerging economy growth are in the past. Mr. X: It seems that both my daughter and I can find some areas of agreement with your views about the economic outlook. You share her expectation that the global growth outlook will stay healthy over the coming year, but you worry about a U.S.-led recession in 2019, something that I certainly sympathize with. But we differ on timing: I fear the downturn could occur even sooner and I know my daughter believes in a longer-lasting upturn. Let's now move onto what this all means for financial markets, starting with bonds. Bond Market Prospects Ms. X: I expect this to be a short discussion as I can see little attraction in bonds at current yields. Even though I expect inflation to stay muted, bonds offer no prospect of capital gains in the year ahead and even the running yield offers little advantage over the equity dividend yield. BCA: As you know, we have believed for some time that the secular bull market in bonds has ended. We expect yields to be under upward pressure in most major markets during 2018 and thus share your view that equities offer better return prospects. By late 2018, it might well be appropriate to switch back into bonds against a backdrop of higher yields and a likely bear market in equities. For the moment, we recommend underweight bond exposure. It is hard to like government bonds when the yield on 10-year U.S. Treasuries is less than 50 basis points above the dividend yield of the S&P 500 while the euro area bond yield is 260 basis points below divided yields (Chart 25). Real yields, using the 10-year CPI swap rate as a measure of inflation expectations, are less than 20 basis points in the U.S. and a negative 113 basis points in the euro area. Even if we did not expect inflation to rise, it would be difficult to recommend an overweight position in any developed country government bonds. One measure of valuation is to compare the level of real yields to their historical average, adjusted by the standard deviation of the gap. On this basis, the most overvalued markets are the core euro area countries, where real yields are 1.5 to 2 standard deviations below their historical average (Chart 26). There are only two developed bond markets where real 10-year government yields currently are above their historical average: Greece and Portugal. This is warranted in Greece where there needs to be a risk premium in case the country is forced to leave the single currency at some point. This is less of a risk for Portugal, making it a more interesting market. Real yields in New Zealand are broadly in line with their historical average, also making it one of the more attractive markets. Chart 25Bonds Yields Offer Little Appeal Chart 26Valuation Ranking Of Developed Bond Markets Mr. X: Given your expectation of higher inflation, would you recommend inflation-protected Treasuries? BCA: Yes, in the sense that they should outperform conventional Treasuries. The 10-year TIPS are discounting average inflation of 1.85% and we would expect this to be revised up during the coming year. However, the caveat is that absolute returns will still be mediocre. Ms. X: You showed earlier that corporate bonds had a reasonable year in 2017, albeit falling far short of the returns from equities. A year ago, you recommended only neutral weighting in investment-grade bonds and an underweight in high yield. But you became more optimistic toward both early in 2017, shifting to an overweight position. Are you thinking of scaling back exposure once again, given the tight level of spreads? BCA: Yes, we were cautious on U.S. corporates a year ago because valuation was insufficient to compensate for the deterioration in corporate balance sheet health. Nonetheless, value improved enough early in 2017 to warrant an upgrade to overweight given our constructive macro and default rate outlook. The cyclical sweet spot for carry trades should continue to support spread product for a while longer. Moreover, value is better than it appears at first glance. The dotted line in Chart 27 shows the expected 12-month option-adjusted spread for U.S. junk bonds after adjusting for our base case forecast for net default losses. At 260 basis points, this excess spread is in line with the historical average. In the absence of any further spread narrowing, speculative-grade bonds would return 230 basis points more than Treasurys in 2018. If high-yield spreads were to tighten by another 150 basis points, then valuations would be at a historical extreme, and that seems unwarranted. An optimistic scenario would have another 100 basis point spread tightening, delivering excess returns of 5%. Of course, if spreads widen, then corporates will underperform. If financial conditions tighten in 2018 as we expect then it will be appropriate to lower exposure to corporates. In the meantime, you should favor U.S. and U.K. corporate bonds to issues in the Eurozone because ECB tapering is likely to spark some spread widening in that market. Mr. X: What about EM hard-currency bonds? BCA: The global economic background is indeed positive for EM assets. However, EM debt is expensive relative to DM investment-grade bonds which, historically, has heralded a period of underperformance (Chart 28). We expect that relative growth dynamics will be more supportive of U.S. corporates because EM growth will lag. Any commodity price weakness and/or a stronger U.S. dollar would also weigh on EM bonds and currencies. Chart 27Not Much Value In U.S. Corporates Chart 28Emerging Market Bonds Are Expensive Mr. X: We have not been excited about the bond market outlook for some time and nothing you have said changes my mind. I am inclined to keep our bond exposure to the bare minimum. Ms. X: I agree. So let's talk about the stock market which is much more interesting. As I mentioned before, I am inclined to remain fully invested in equities for a while longer, while my father wants to start cutting exposure. Equity Market Outlook BCA: This is one of those times when it is important to draw a distinction between one's forecast of where markets are likely to go and the appropriate investment strategy. We fully agree that the conditions that have driven this impressive equity bull market are likely to stay in place for much of the next year. Interest rates in the U.S. and some other countries are headed higher, but they will remain at historically low levels for some time. Meanwhile, in the absence of recession, corporate earnings still have upside, albeit not as much as analysts project. However, we have a conservative streak at BCA that makes us reluctant to chase markets into the stratosphere. For long-term investors, our recommended strategy is to gradually lower equity exposure to neutral. However, those who are trying to maximize short-term returns should stay overweight and wait for clearer signs that tighter financial conditions are starting to bite on economic activity. Chart 29Reasons For Caution On U.S. Stocks Getting down to specifics, here are the trends that give us cause for concern and they are all highlighted in Chart 29. Valuation: Relative to both earnings and book value, the U.S. equity market is more expensive than at any time since the late 1990s tech bubble. The price-earnings ratio (PER) for the S&P 500 is around 30% above its 60-year average on the basis of both trailing operating earnings and a 10-year average of earnings. The market is not expensive on a relative yield basis because interest rates are so low, but that will change as rates inevitably move higher. Other developed markets are not as overvalued as the U.S., but neither are they cheap. Earnings expectations: The performance of corporate earnings throughout this cycle - particularly in the U.S. - has been extremely impressive give the weaker-than-normal pace of economic growth. However, current expectations are ridiculously high. According to IBES data, analysts expect long-run earnings growth of around 14% a year in both the U.S. and Europe. Even allowing for analysts' normal optimistic bias, the sharp upward revision to growth expectations over the past year makes no sense and is bound to be disappointed. Investor complacency: We all know that the VIX index is at a historical low, indicating that investors see little need to protect themselves against market turmoil. Our composite sentiment indicator for the U.S. is at a high extreme, further evidence of investor complacency. These are classic contrarian signs of a vulnerable market. Most bear markets are associated with recessions, with the stock market typically leading the economy by 6 to 12 months (Chart 30). The lead in 2007 was an unusually short three months. As discussed earlier, we do not anticipate a U.S. recession before 2019. If a recession were to start in mid-2019, it would imply the U.S. market would be at risk from the middle of 2018, but the rally could persist all year. Of course, the timing of a recession and market is uncertain. So it boils down to potential upside gains over the next year versus the downside risks, plus your confidence in being able to time the top. Chart 30Bear Markets And Recessions Usually Overlap We are not yet ready to recommend that you shift to an underweight position in equities. A prudent course of action would be to move to a broadly neutral position over the next few months, but we realize that Ms. X has a higher risk tolerance than Mr. X so we will leave you to fight over that decision. The timing of when we move to an underweight will depend on our various economic, monetary and market indicators and our assessment of the risks. It could well happen in the second half of the year. Mr. X: My daughter was more right than me regarding our equity strategy during the past year, so maybe I should give her the benefit of the doubt and wait for clearer signs of a market top. Thus far, you have focused on the U.S. market. Last year you preferred developed markets outside the U.S. on the grounds of relative valuations and relative monetary conditions. Is that still your stance? BCA: Yes it is. The economic cycle and thus the monetary cycle is far less advanced in Europe and Japan than in the U.S. This will provide extra support to these markets. At the same time, profit margins are less vulnerable outside the U.S. and, as you noted, valuations are less of a problem. In Chart 31, we show a valuation ranking of developed equity markets, based on the deviation of cyclically-adjusted PERs from their historical averages. The chart is not meant to measure the extent to which Portugal is cheap relative to the U.S., but it indicates that Portugal is trading at a PER far below its historical average while that of the U.S. is above. You can see that the "cheaper" markets tend to be outside the U.S. Japan's reading is flattered by the fact that its historical valuation was extremely high during the bubble years of the 1980s, but it still is a relatively attractive market. Chart 31Valuation Ranking Of Developed Equity Markets From a cyclical standpoint, we are still recommending overweight positions in European and Japanese stocks relative to the U.S., on a currency-hedged basis. Nevertheless, market correlations are such that a sell-off in the U.S. will be transmitted around the world (Chart 32). Chart 32When the U.S. Market Sneezes, The World Catches A Cold Ms. X: I would like to turn the focus to emerging equity markets. You have been cautious on these for several years and that worked out extremely well until 2017. I note from your regular EM reports that you have not changed your stance. Why are you staying bearish given that you see an improvement in global growth and further potential upside in developed equity prices? BCA: The emerging world did extremely well over many years when global trade was expanding rapidly, China was booming, commodity prices were in a powerful bull market and capital inflows were strong. Those trends fostered a rapid expansion in credit-fueled growth across the EM universe and meant that there was little pressure to pursue structural reforms. However, the 2007-09 economic and financial crisis marked a major turning point in the supports to EM outperformance. As we noted earlier, the era of rapid globalization has ended, marking an important regime shift. Meanwhile, China's growth rate has moderated and the secular bull market in commodities ended several years ago. We do not view the past year's rebound in commodities as the start of a major new uptrend. Many emerging equity markets remain highly leveraged to the Chinese economy and to commodity prices (Chart 33). Although we expect the Chinese economy to hold up, growth is becoming less commodity intensive. Finally, the rise in U.S. interest rates is a problem for those countries that have taken on a marked increase in foreign currency debt. This will be made even worse if the dollar appreciates. Obviously, the very term "emerging" implies that this group of countries has a lot of upside potential. However, the key to success is pursuing market-friendly reforms, rooting out corruption and investing in productive assets. Many countries pay only lip service to these issues. India is a case in point where there is growing skepticism about the Modi government's ability to deliver on major reforms. The overall EM index does not appear expensive, with the PER trading broadly in line with its historical average (Chart 34). However, as we have noted in the past, the picture is less compelling when the PER is calculated using equally-weighted sectors. The financials and materials components are trading at historically low multiples, dragging down the overall index PER. Emerging market equities will continue to rise as long as the bull market in developed markets persists, but we expect them to underperform on a relative basis. Chart 33Drivers Of EM Performance Chart 34Emerging Markets Fundamentals Mr. X: One last question on equities from me: do you have any high conviction calls on sectors? BCA: A key theme of our sector view is that cyclical stocks should outperform defensives given the mature stage of the economic cycle. We are seeing the typical late-cycle improvement in capital spending and that will benefit industrials, and we recommend an overweight stance in that sector. Technology also is a beneficiary of higher capex but of course those stocks have already risen a lot, pushing valuations to extreme levels. Thus, that sector warrants only a neutral weighting. Our two other overweights are financials and energy. The former should benefit from rising rates and a steeper yield curve while the latter will benefit from firm oil prices. If, as we fear, a recession takes hold in 2019, then obviously that would warrant a major shift back into defensive stocks. For the moment, the positive growth outlook will dominate sector performance. Ms. X: I agree that the bull market in equities, particularly in the U.S., is very mature and there are worrying signs of complacency. However, the final stages of a market cycle can sometimes be very rewarding and I would hate to miss out on what could be an exciting blow-off phase in 2018. As I mentioned earlier, my inclination is to stay heavily invested in equities for a while longer and I have confidence that BCA will give me enough of a warning when risks become unacceptably high. Of course, I will have to persuade my father and that may not be easy. Mr. X: You can say that again, but we won't bother our BCA friends with that conversation now. It's time to shift the focus to commodities and currencies and I would start by commending you on your oil call. You were far out of consensus a year ago when you said the risks to crude prices were in the upside and you stuck to your guns even as the market weakened in the first half. We made a lot of money following your energy recommendations. What is your latest thinking? Commodities And Currencies BCA: We had a lot of conviction in our analysis that the oil market would tighten during 2017 against a backdrop of rising demand and OPEC production cuts, and that view turned out to be correct. As we entered the year, the big reason to be bearish on oil prices was the bloated level of inventories. We forecast that inventories would drop to their five-year average by late 2017, and although that turned out to be a bit too optimistic, the market tightened by enough to push prices higher (Chart 35). Chart 35Oil Market Trends The forces that have pushed prices up will remain in force over the next year. Specifically, our economic view implies that demand will continue to expand, and we expect OPEC 2.0 - the producer coalition of OPEC and non-OPEC states, led by Saudi Arabia and Russia - to extend its 1.8 million b/d production cuts to at least end-June. On that basis, OECD inventories should fall below their five-year average by the end of 2018. We recently raised our 2018 oil price target to an average of $65 in 2018. Of course, the spot market is already close to that level, but the futures curve is backwardated and that is likely to change. We continue to see upside risks to prices, not least because of potential production shortfalls from Venezuela, Nigeria, Iraq and Libya. Mr. X: The big disruptor in the oil market in recent years was the dramatic expansion in U.S. shale production. Given the rise in prices, could we not see a rapid rebound in shale output that, once again, undermines prices? BCA: Our modeling indicates that U.S. shale output will increase from 5.1 mb/d to 6.0 mb/d over the next year, in response to higher prices. This is significant, but will not be enough to materially change the global oil demand/supply balance. Longer run, the expansion of U.S. shale output will certainly be enough to prevent any sustained price rise, assuming no large-scale production losses elsewhere. A recent report by the International Energy Agency projected that the U.S. is destined to become the global leader in oil and gas production for decades to come, accounting for 80% of the rise in global oil and gas supply between 2010 and 2025. Ms. X: You have suggested that China's economic growth is becoming less commodity intensive. Also, you have shown in the past that real commodity prices tend to fall over time, largely because of technological innovations. What does all this imply for base metals prices over the coming year? BCA: The base metals story will continue to be highly dependent on developments in China. While the government is attempting to engineer a shift toward less commodity-intensive growth, it also wants to reduce excess capacity in commodity-producing sectors such as coal and steel. Base metals are likely to move sideways until we get a clearer reading on the nature and speed of economic reforms. We model base metals as a function of China's PMIs and this supports our broadly neutral stance on these commodities (Chart 36). Chart 36China Drives Metals Prices Mr. X: As usual, I must end our commodity discussion by asking about gold. Last year, you agreed that an uncertain geopolitical environment coupled with continued low interest rates should support bullion prices, and that was the case with a respectable 12% gain since the end of 2016. You also suggested that I should not have more than 5% of my portfolio in gold which is less than I am inclined to own. It still looks like a gold-friendly environment to me. Ms. X: Let me just add that this is one area where my father and I agree. I do not consider myself to be a gold bug, but I think bullion does provide a good hedge against shocks in a very uncertain economic and political world. I would also be inclined to hold more than 5% of our portfolio in gold. BCA: There will be opposing forces on gold during the coming year. On the positive side, it is safe to assume that geopolitical uncertainties will persist and may even intensify, and there also is the potential for an increase in inflation expectations that would support bullion. On the negative side, rising interest rates are not normally good for gold and there likely will be an added headwind from a firmer U.S. dollar. Gold appears to be at an important point from a technical perspective (Chart 37). It currently is perched just above its 200-day average and a key trend line. A decisive drop below these levels would be bearish. At the same time, there is overhead resistance at around 1350-1360 and prices would have to break above that level to indicate a bullish breakout. Traders' sentiment is at a broadly neutral level, consistent with no clear conviction about which way prices will break. There is no science behind our recommendation of keeping gold exposure below 5%. That just seems appropriate for an asset that delivers no income and where the risk/reward balance is fairly balanced. Ms. X: You referred to the likelihood of a firmer dollar as a depressant on the gold price. You also were bullish on the dollar a year ago, but that did not work out too well. How confident are you that your forecast will fare better in 2018? BCA: We did anticipate that the dollar would experience a correction at the beginning of 2017, but we underestimated how profound this move would be. A combination of factors explains this miscalculation. Chart 37Gold At A Key Level It first began with positioning. We should have paid more attention to that fact that investors were massively bullish and long the dollar at the end of 2016, making the market vulnerable to disappointments. And disappointment did come with U.S. inflation weakening and accelerating in the euro area. Additionally, there were positive political surprises in Europe, especially the presidential victory of Emmanuel Macron in France. In the U.S., the government's failure to repeal Obamacare forced investors to lower expectations about fiscal stimulus. As a result, while investors were able to price in an earlier first hike by the ECB, they cut down the number of rate hikes they anticipated out of the Fed over the next 24 months. In terms of the current environment, positioning could not be more different because investors are aggressively shorting the dollar (Chart 38). The hurdle for the dollar to deliver positive surprises is thus much lower than a year ago. Also, we remain confident that tax cuts will be passed in the U.S. by early 2018. As we discussed earlier, U.S. GDP will remain above potential, causing inflation pressures to build. This will give the Fed the leeway to implement its planned rate hikes, and thus beat what is currently priced in the market. This development should support the dollar in 2018. Ms. X: A bullish view on the U.S. dollar necessarily implies a negative view on the euro. However, the European economy seems to have a lot of momentum, and inflation has picked up, while U.S. prices have been decelerating. To me, this suggests that the ECB also could surprise by being more hawkish than anticipated, arguing against any major weakness in the euro. BCA: The European economy has indeed done better than generally expected in the past year. Also, geopolitical risks were overstated by market participants at the beginning of 2017, leaving less reason to hide in the dollar. However, the good news in Europe is now well known and largely discounted in the market. Investors are very long the euro, by both buying EUR/USD and shorting the dollar index (Chart 39). In that sense, the euro today is where the dollar stood at the end of 2016. Chart 38Too Much Pessimism On The Dollar Chart 39Positioning Risk In EUR/USD Valuations show a similar picture. The euro might appear cheap on a long-term basis, but not so much so that its purchasing power parity estimate - which only works at extremes and over long-time periods - screams a buy. Moreover, the euro has moved out of line with historical interest rate parity relationships, warning that the currency is at risk if the economy disappoints. Overall, we expect EUR/USD to trade around 1.10 in 2018. Long-run, the picture is different because a U.S. recession in 2019 would trigger renewed broad-based weakness in the dollar. Mr. X: I have been perplexed by the yen's firmness in the past year, with the currency still above its end-2016 level versus the dollar. I expected a lot more weakness with the central bank capping bond yields at zero and more or less monetizing the government deficit. A year ago you also predicted a weak yen. Will it finally drop in 2018? BCA: We were not completely wrong on the yen as it has weakened over the past year on a trade-weighted basis and currently is about 2% below its end-2016 level. But it has risen slightly against the U.S. dollar. In the past couple of years, the yen/dollar rate has been highly correlated with real bond yield differentials (Chart 40). These did not move against the yen as much as we expected because U.S. yields drifted lower and there was no major change in relative inflation expectations. Chart 40Bond Yield Differentials Drive The Yen The real yield gap is likely to move in the dollar's favor over the next year, putting some downward pressure on the yen. Meanwhile, the Bank of Japan will continue to pursue a hyper-easy monetary stance, in contrast to the Fed's normalization policy. However, it is not all negative: the yen is cheap on a long-term basis, and Japan is an international net creditor to the tune of more than 60% of GDP. Investors are also quite short the yen as it remains a key funding currency for carry trades. Thus, it will continue to benefit each time global markets are gripped with bouts of volatility. It remains a good portfolio hedge. Ms. X: Are any other currency views worth noting? BCA: The outlook for sterling obviously will be tied to the Brexit negotiations. Having fallen sharply after the Brexit vote, sterling looks cheap relative to its history. This has allowed it to hold in a broad trading range over the past 18 months, even though the negotiations with the EU have not been going well. At this stage, it is hard to know what kind of deal, if any, will emerge regarding Brexit so we would hedge exposure to sterling. Our optimism toward the oil price is consistent with a firm Canadian dollar, but developments in the NAFTA negotiations represent a significant risk. At the moment, we are overweight the Canadian dollar, but that could change if the NAFTA talks end badly. We still can't get enthusiastic about emerging market currencies even though some now offer reasonable value after falling sharply over the past few years. Mr. X: We can't leave currencies without talking about Bitcoin and cryptocurrencies in general. I like the idea of a currency that cannot be printed at will by governments. There are too many examples of currency debasement under a fiat money system and the actions of central banks in recent years have only served to increase my mistrust of the current monetary system. But I can't profess to fully understand how these cryptocurrencies work and that makes me nervous about investing in them. What are your thoughts? BCA: You are right to be nervous. There have been numerous cases of hackers stealing Bitcoins and other cryptocurrencies. Also, while there is a limit to the number of Bitcoins that can be issued, there is no constraint on the number of possible cryptocurrencies that can be created. Thus, currency debasement is still possible if developers continue creating currencies that are only cosmetically different from the ones already in existence. Moreover, we doubt that governments will sit idly by and allow these upstart digital currencies to become increasingly prevalent. The U.S. Treasury derives $70 billion a year in seigniorage revenue from its ability to issue currency which it can then redeem for goods and services. At some point, governments could simply criminalize the use of cryptocurrencies. This does not mean that Bitcoin prices cannot rise further, but the price trend is following the path of other manias making it a highly speculative play (Chart 41). If you want more detail about our thoughts on this complex topic then you can read the report we published last September.2 Chart 41Bitcoin Looks Like Other Bubbles Ms. X: I don't fear bubbles and manias as much as my father and have made a lot of money during such episodes in the past. But I am inclined to agree that Bitcoin is best avoided. The topic of manic events presents a nice segue into the geopolitical environment which seems as volatile as ever. Geopolitics Ms. X: Which geopolitical events do you think will have the biggest impact on the markets over the coming year? BCA: Domestic politics in the U.S. and China will be very much in focus in 2018. In the U.S., as we discussed, the Republicans will pass tax cuts but it is unclear whether this will help the GOP in the November midterm elections. At this point, all of our data and modeling suggests that Democrats have a good chance of picking up the House of Representatives, setting a stage for epic battles with President Trump about everything under the sun. In China, we are watching carefully for any sign that Beijing is willing to stomach economic pain in the pursuit of economic reforms. The two reforms that would matter the most are increased financial regulation and more aggressive purging of excess capacity in the industrial sector. The 19th Party Congress marked a serious reduction in political constraints impeding President Xi's domestic agenda. This means he could launch ambitious reforms, akin to what President Jiang Zemin did in the late 1990s. While this is a low-conviction view, and requires constant monitoring of the news and data flow out of China, it would be a considerable risk to global growth. Reforms would be good for China's long-term outlook, but could put a significant damper on short-term growth. The jury is out, but the next several months will be crucial. Three other issues that could become market-relevant are the ongoing North Korean nuclear crisis, trade protectionism, and tensions between the Trump administration and Iran. The first two are connected because a calming of tensions with North Korea would give the U.S. greater maneuvering room against China. The ongoing economic détente between the U.S. and China is merely a function of President Trump needing President Xi's cooperation on pressuring North Korea. But if President Trump no longer needs China's help with Kim Jong-Un, he may be encouraged to go after China on trade. As for Iran, it is not yet clear if the administration is serious about ratcheting up tensions or whether it is playing domestic politics. We suspect it is the latter implying that the market impact of any brinkmanship will be minor. But our conviction view is low. Mr. X: We seem to be getting mixed messages regarding populist pressures in Europe. The far right did not do as well as expected in the Netherlands or France, but did well in Austria. Also, Merkel is under some pressure in Germany. BCA: We don't see much in the way of mixed messages, at least when it comes to support for European integration. In Austria, the populists learned a valuable lesson from the defeats of their peers in the Netherlands and France: stay clear of the euro. Thus the Freedom Party committed itself to calling a referendum on Austria's EU membership if Turkey was invited to join the bloc. As the probability of that is literally zero, the right-wing in Austria signaled to the wider public that it was not anti-establishment on the issue of European integration. In Germany, the Alternative for Germany only gained 12.6%, but it too focused on an anti-immigration platform. The bottom line for investors is that the European anti-establishment right is falling over itself to de-emphasize its Euroskepticism and focus instead on anti-immigration policies. For investors, the former is far more relevant than the latter, meaning that the market relevance of European politics has declined. One potential risk in 2018 is the Italian election, likely to be held by the end of the first quarter. However, as with Austria, the anti-establishment parties have all moved away from overt Euroskepticism. At some point over the next five years, Italy will be a source of market risk, but in this electoral cycle and not with economic growth improving. Ms. X: The tensions between the U.S. and North Korea, fueled by two unpredictable leaders, have me very concerned. I worry that name-calling may slide into something more serious. How serious is the threat? BCA: The U.S.-Iran nuclear negotiations are a good analog for the North Korean crisis. The U.S. had to establish a "credible threat" of war in order to move Iran towards negotiations. As such, the Obama administration ramped up the war rhetoric - using Israel as a proxy - in 2011-2012. The negotiations with Iran did not end until mid-2015, almost four years later. We likely have seen the peak in "credible threat" display this summer between the U.S. and North Korea. The next two-to-three months could revisit those highs as North Korea responds to President Trump's visit to the region, as well as to the deployment of the three U.S. aircraft carriers off the coast of the Korean Peninsula. However, we believe that we have entered the period of "negotiations." It is too early to tell how the North Korean crisis will end. We do not see a full out war between either of the main actors. We also do not see North Korea ever giving up its nuclear arsenal, although limiting its ballistic technology and toning down its "fire and brimstone' rhetoric is a must. The bottom line is that this issue will remain a source of concern and uncertainty for a while longer. Conclusions Mr. X: This seems a good place to end our discussion. We have covered a lot of ground and your views have reinforced my belief that it would make good sense to start lowering the risk in our portfolio. I know that such a policy could leave money on the table as there is a reasonable chance that equity prices may rise further. But that is a risk I am prepared to take. Ms. X: I foresee some interesting discussions with my father when we get back to our office. At the risk of sounding reckless, I remain inclined to stay overweight equities for a while longer. I am sympathetic to the view that the era of hyper-easy money is ending and at some point that may cause a problem for risk assets. However, timing is important because, in my experience, the final stages of a bull market can deliver strong gains. BCA: Good luck with those discussions! We have similar debates within BCA between those who want to maximize short-run returns and those who take a longer-term view. Historically, BCA has had a conservative bias toward investment strategy and the bulk of evidence suggests that this is one of these times when long-run investors should focus on preservation of capital rather than stretching for gains. Our thinking also is influenced by our view that long-run returns will be very poor from current market levels. Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation (Table 3). That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. There is a negligible equity risk premium on offer, implying that stock prices have to fall at some point to establish higher prospective returns. Table 310-Year Asset Return Projections The return calculations for equities assume profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or PERs stay at historically high levels. In that case, equities obviously would do better than our estimates. In terms of the outlook for the coming year, a lot will depend on the pace of economic growth. We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. That is possible, but we would not make it our base case scenario. Ms. X: You have left us with much to think about and I am so glad to have finally attended one of these meetings. My father has always looked forward to these discussions every year and I am very happy to be joining him. Many thanks for taking the time to talk to us. Before we go, it would be helpful to have a recap of your key views. BCA: That will be our pleasure. The key points are as follows: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflation pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets. The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the odds of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the euro area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China's economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their "dots" projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal currently have 10-year government bond real yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The euro area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 20, 2017 1 This comprises consumer spending on durables, housing and business investment in equipment and software. 2 Please see 'Bitcoin's Macro Impact', BCA Global Investment Strategy Special Report, September 15, 2017.

Highlights The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.

Special Report

Highlights Clients frequently ask us what long-term returns they should assume when constructing strategic portfolios. In this report, we use a range of methodologies to arrive at reasonable return assumptions for bonds, equities, alternative assets, and currencies on a 10-15 year investment horizon. We conclude that global bonds are likely to return around 1.5% in nominal terms (compared to 5.3% over the past 20 years), and global equities 4.6% (compared to 6.1%). Alternative assets look rather more attractive with, for example, private equity projected to return 9% and real estate 7.1%. Nonetheless, the typical pension fund portfolio, consisting of 50% equities, 30% fixed income, and 20% alts, will be unable to achieve its return target (still typically 7% or higher). Feature Pension plan sponsors and wealth managers need realistic assumptions about the likely returns from different assets in order to construct strategic portfolios, for example when calculating the efficient frontier using a mean-variance optimizer (MVO). Using historical data is the simplest way to do this, but can be very misleading: for example, global bonds have delivered an annual nominal return of 5.3% over the past 20 years but, with bond yields currently so low, it is almost mathematically impossible for them to return anything close to that over coming years (our estimate for future returns is 1.5%). This Special Report is our attempt to produce long-run return assumptions for strategic portfolios, something that GAA clients frequently ask us for. We want to emphasize that these are reasonable assumptions, not forecasts. The value of forecasting the world economy over the next decade or more is questionable. Consider if we had carried out this exercise in 2002: how likely is it that we would have predicted the rise and fall of emerging markets, the U.S. housing crisis, and the subsequent "secular stagnation"? Our analysis, therefore, is mostly based on the philosophy that long-run historical relationships (for example, credit spreads, or the excess return of small cap stocks) are fairly constant, and that most variables (profit margins, valuation, productivity) mean revert over the long term. Our time horizon is 10-15 years. We chose this - rather than the five or seven years that is perhaps more common in such analyses - because it is closer to the investment horizon of pension funds and most individual investors. It also allows us to avoid making a call on where we are currently in the cycle, and how long the next recession and expansion will last. It is likely we are close to the peak of the current economic expansion and equity bull market (the "X" on Chart 1): choosing a shorter time horizon would mean making judgements about the timing of the cycle. Conceptually, we prefer to forecast the trend line on the chart. Chart 1Stylized Trend Versus Cyclical Movements Our assumptions are inevitably approximate. In many cases (particularly for equity returns), we use multiple methodologies and take the average result. Does it matter that the estimation error of our assumptions is likely to be large? Most academic evidence finds not.1 The reason is that, for closely correlated assets, errors in the return estimates (and therefore the optimal weights in a portfolio) will not greatly affect a portfolio's risk and return; while, for assets that are very different, errors in the estimates will not have much effect on the optimal portfolio weights. Rough estimates, therefore, are sufficient for portfolio construction purposes. In any case, using common-sense projections is better than unrealistic historical averages, and investors do need some assumptions to work with when constructing portfolios. How To Forecast Economic Growth A key input (especially when considering earnings growth, which is one factor driving equity returns) is the likely rate of economic growth in various countries and regions over our time horizon. Our simplified way of deriving this is to assume that GDP growth is a factor of (1) demographics (specifically, the growth in the population of working age), and (2) productivity growth. (We assume that capital intensity is steady.) For the demographic assumptions, we use the United Nations' median forecast of the annual growth in population aged 25-64 between 2015 and 2030 (Table 1). Productivity growth is harder to estimate. Productivity has been poor in recent years compared to history (Chart 2). There is significant uncertainty about whether this is caused by cyclical factors (the Great Recession, for example) or structural factors (the end of positive effects from the IT revolution etc.), and whether a potential new wave of technology (artificial intelligence, self-driving vehicles) will raise productivity in future. Table 1Demographic Assumptions Chart 2Productivity Growth Our approach is to assume that productivity in the U.S. will return to its 40-year average, and that productivity growth in the main European economies will be 50 bp lower than the U.S. and in Japan 80 bp lower (in line with recent averages). The estimate is harder for emerging markets, so we use two scenarios: one in which structural reforms, particularly in China, bring productivity growth back up to the average of the past 10 years, 3.5%; and a second scenario in which governments fail to reform, and therefore productivity growth continues to fall to only 1%. For inflation, we assume that central banks over the long-term largely achieve their current inflation goals. The results of our assumptions for GDP growth are shown in Table 2. Table 3 shows the summary of our results: the 10-15 year return assumptions for all the assets in our analysis. We also show historic returns and volatility for comparison (for the past 20 years, where data is available). Below, we describe in detail how we arrived at these numbers. Table 2GDP Growth Assumptions Table 3BCA Assumed Returns All our results are shown in nominal terms and in local currencies. While strictly speaking, it might be theoretically better to estimate real returns, in practice most investors and advisers tend to work on a nominal basis. Moreover, since we have made assumptions for inflation in each region, it is simple to translate our nominal returns into real ones. There is also a trade-off between inflation and currency movements (and interest rates). At the end of the report, we consider the impact of relative inflation rates on currency returns, allowing investors to work the returns back into their own currencies. 1. Fixed income We start from a base that is known: the return on long-term government bonds. If an investor today buys a 10-year U.S. Treasury bond, his or her annual nominal return over the next 10 years will almost certainly be 2.3% (today's yield). The only uncertainties come from (1) reinvesting coupons at the future rate of interest, but the impact of this is small, and (2) the (presumably minimal) risk of a U.S. government default. Of course, investors do not own just 10-year bonds, and indeed the average duration of U.S. Treasuries is currently 5.7 years. But changes in interest rates make relatively little difference to future returns: a rise in interest rates causes a capital loss but a higher yield on rolled-over positions after bonds mature (though, admittedly, the convexity effect is greater when rates are low, as they are now). Even if interest rates were to double over the next decade, the return from U.S. Treasuries would fall only to around 1.5% and, if interest rates fell to 0%, the return would be only about 3%. Moreover, the effect diminishes over time as more bonds are redeemed at par. Empirically, we can see that there is a strong correlation between starting yield on 10-year bonds and long-term returns from U.S. Treasuries (Chart 3). Chart 3Government Bond Returns Driven By The Starting Yield For our cash assumption, we first calculate a proxy for the current cash yield using the average spread between 10-year government bonds and three-month bills over a long-run history (using data from Dimson, Marsh and Staunton which goes back to 1900 and covers a range of countries, Table 4).2 While it is true that the yield curve steepens and flatten along with the cycle, the average yield curve shape should be a good proxy for long-term future expected returns. Of course, this assumes that the term premium comes back. It may not if bonds now are a good hedge against recession risk. However, we also need to take into account that interest rates and inflation are likely to change over the next 10-15 years. We assume that both will rise to an equilibrium level over that time. Our assumption is that central banks will get close to hitting their inflation targets (in the U.S., 2% on PCE inflation, which translates into 2.5% on CPI; in Europe, "around but below 2%"; and in Japan, 2%). For the equilibrium real rate, we take BCA's current estimate (Chart 4) and assume a small rise over the next decade as some of the after-effects of the Great Recession and secular stagnation wear off: to 0.4% in the U.S., -0.1% in the euro area, and -0.2% in Japan. Table 4Historic Spread Government Bonds To Bills (1900-2016) Chart 4Current Equilibrium Real Rates Our calculation of the return from cash over the 10-15 year horizon is based on a steady rise from the current cash return to that implied by the inflation and equilibrium real rate assumptions (Table 5). Table 5Calculation Of Assumption For Cash Return For other fixed-income instruments, we make the following assumptions: Government bonds. We assume that the spread between 10-year and 7-year bonds and 3-month bills will be similar to the historical average (Chart 5), and calculate the return from the government bond index based on this and our estimate for 10-year returns, adjusted by the duration of outstanding bonds in the index: 5.7 years for the U.S., 7.1 for Europe and 8.6 for Japan. For U.S. investment-grade and high-yield corporate bonds, we take the average spread, default rate, and recovery rate in history (Table 6). Obviously, spreads and default rates, especially for high-yield bonds, also jump around massively over the cycle (Chart 6), but we think it is reasonable to assume in our long-term projections that they revert to the mean. Reliable data for European and Japanese credit has a short history but, over the past 10 years, spreads and default rates have been similar to the U.S., so we use the U.S. assumptions for these markets too. Chart 5Yield Curves Table 6U.S. Corporate Credit Assumptions Chart 6Credit Spreads And Default Rates Move With The Cycle Government-related bonds and securitized bonds (MBS, ABS etc.) are an important part of the Barclay's Aggregate Bond indexes: in the U.S., for example, securitized bonds comprise 31% of the index, and government-related ones 7%; in Europe, the weights are 8% and 17% respectively. For our projections of government-related bonds, we assume historic average spreads will continue (Table 7). For securitized bonds, we assume that the historic average spread in the U.S. will continue, and will be the same in Europe and Japan (where historic data is less readily available). Inflation-linked bonds. We assume that the average real yield of the past 10 years, 0%, will continue in future (Chart 7). Table 7Spreads Over Government Bonds Chart 7Real Yield On U.S. TIPs 2. Equities There are a number of ways to think about forward equity returns, all with a high degree of uncertainty. These could be based on starting valuations (but which valuation measure to use?); related to likely earnings growth in future years (hard to forecast); or based on a reversion to the mean of valuations and profits. We decided to take a range of different measures, and average the results. In practice, the results are similar, except for emerging markets (see below for more on EM). Table 8 summarizes the equity return calculations. Table 8Equity Return Calculations AVERAGE EQUITY The thinking behind the six measures we use is as follows. Equity risk premium (ERP). The most obvious methodology: historically, over the long run equities have returned more than government bonds. But which risk premium to use? Dimson, Marsh and Staunton's work includes the excess performance of equities over bonds since 1900 for a range of countries (Table 9). We decided not to choose a different ERP for each developed region, as the historical data would suggest, since it is difficult to argue that the U.S. is likely to be riskier in future than Europe and since, for parts of this history, Japan and the U.S. were essentially emerging markets. We, therefore, take a rounded average of world ERP over the past 116 years, 3.5%. For emerging markets, we multiply this by the average beta of EM relative to global equities over the past 30 years, 1.2, to give an ERP of 4.2%. Growth model. Think of a Gordon Growth Model, which defines the return from equities as the starting dividend yield plus future earnings growth (strictly speaking, dividend growth; we are assuming that the payout ratio will stay constant). We need to make a couple of adjustments to this. First, earnings growth has historically been correlated to nominal GDP growth but has lagged it - in the U.S. by 1.5 percentage points in the period 1918-2016 - although, since 1981, earnings have grown significantly faster than GDP (Chart 8). For the future, we assume that the long-run lag returns. Second, we need to add share buybacks to the dividend yield since, in some countries, such as the U.S., for tax reasons companies prefer to buy back shares rather than increase dividends. However, we should do this on a net basis since equity holders are penalized by companies that issue new shares. In the U.S. net equity withdrawal has been 0.3% over the past 10 years, but in both Europe and Japan, annual net new equity issuance has averaged 1.6% (Chart 9). In EM, the dilution has been even more extreme, averaging 6% over the past 10 years (and much more over the past 25 years). We subtract this dilution from future returns. Table 9Equity Excess Return Over Bonds Chart 8U.S. EPS Growth Versus Nominal GDP Growth Chart 9Net Equity Issuance Growth plus reversion to the mean. This takes the Gordon Growth Model but adds to it an assumption that PE multiples and profit margins revert to the historical mean. We again use dividend yield adjusted by net equity issuance. We assume that the current trailing PE and profit margin revert to the average since 1980 (see Table 8 above for the data) over the next 10 years. In the U.S., PE and margins are currently somewhat higher than history, but this is less the case in Europe or Japan (Charts 10 and 11). Additionally, assuming that the mean reversion happens over 10 years means that the effect on annual returns is not especially large, even for the U.S. Chart 10Net Profit Margin Chart 11Trailing PE History Earnings yield (EY). The simplest of the three valuation measures we use, the assumption is that companies reward shareholders either by paying them a dividend this year, or by reinvesting retained earnings to pay dividends in future. If you assume (admittedly a rash assumption) that the future return on investment will be similar to the current return on investment, it should be immaterial how the company pays out to shareholders. Therefore, the trailing earnings yield (1/PE ratio) should be a good proxy for future returns. Empirically, the relationship between earnings yield and 10-year future returns has been quite strong (Chart 12). However, returns have been somewhat higher on average than the EY would indicate (between 1900 and 2006, 9.7% versus an average EY of 7.5%) mainly because of rising PE multiples since 1980 (Chart 13). We think it unlikely that valuations will continue to rise, and so the EY should be a reasonable guide to future returns. Chart 12Earnings Yield And 10-Year Future Returns Chart 13Trailing Price/Earnings Multiple S&P500 Shiller PE. The cyclically-adjusted price/earnings ratio (CAPE, or Shiller PE) - the current share price divided by the 10 year average of historic inflation-adjusted earnings - has historically had a good correlation with future long-term returns (Chart 14). A regression model of this indicates that the current Shiller PE points to long-run forward returns for the U.S. of 4.9%, for Japan 3.6%, Europe 8.5% and EM 10.8%. Valuation composite. The Shiller PE has some flaws, for example in using a fixed 10-year period for earnings when the length of cycles varies. It has not necessarily mean-reverted in history (perhaps because of long-term trends in interest rates, which it doesn't take into account). It may be more reasonable, then, to use a mixture of different valuation metrics. BCA's Composite Valuation Indicator has had a good correlation with long-run future returns (Chart 15).3 A regression model of this indicator against 15-year returns currently points to returns from the U.S. of 5.2%, Europe of 4.1%, Japan 5.1% and EM 11.0%. Small-cap stocks. We take the 2.4% excess annual return of small cap stocks over large caps in the U.S. for 1926-2016, as calculated by Dimson, Marsh & Staunton. Chart 14Shiller PE Versus ##br##15-Year Equity Return Chart 15Composite Valuation Measure Versus ##br##Long-Run Future Returns Emerging Markets The return assumption for emerging market equity returns has a much higher degree of uncertainty. On our three valuation measures, EM equities look attractive: the average return expectation of the three valuation indicators points to an annual return of 9.4%. However, the growth outlook is murky: as described above, a wave of structural reform in emerging markets, especially China, would be necessary to keep productivity - and, therefore, earnings growth - up, in order for returns to be as good as the current valuation level suggests. Another worry is the degree of equity dilution: it has averaged 6% a year over the past 10 years, and is unlikely to fall much unless corporate governance improves significantly. The range of expected returns derived from our various methodologies, therefore, varies from -1% to +11% a year. Moreover, as described in the currency section below, investors should expect a depreciation in some EM currencies over the next decade, which will also eat into returns. However, due to the influence of China, where the currency is projected to appreciate almost 2% a year against the USD, the EM equity index will see an overall boost to USD-based returns due to the currency effect. 3. Alternative Assets We consider the likely future returns for nine of the 10 alternative assets that Global Asset Allocation regularly covers (we omit wine, which is hard to value on the basis of fundamental macro factors and, anyway, is owned by few institutional investors).4 Alts are harder to forecast than public securities since data is less easily available (and may be only quarterly and based on estimated values), and since some alternative assets have not existed in their current form for very long (venture capital, for example). Moreover, alternative assets tend to have non-normal returns with skewed distributions. Table 10 shows the historical returns and volatility of the nine alternative asset classes both over the longest period for which we have data, and since 1997, when we have data for all of them. Table 10Returns And Volatility For Alternative Assets We, therefore, take a more ad hoc approach, projecting each asset class differently. Generally, we assume that future returns will look similar to historical ones. Specifically, the assumptions we use are as follows. Hedge funds. We assume a return of cash + 3.5%. Hedge fund returns have trended down over time (Chart 16), as more entrants have arbitraged away alpha. We choose to use the average return over cash of the past 10 years, 3.5% (net of fees). It is unlikely that hedge funds returns will rise back anywhere close to earlier levels, for example that of the 1990s when they returned cash +14%. Chart 16Hedge Fund Historic Returns U.S. Direct real estate. We find reasonably good results (R2 = 24%) from regressing U.S. nominal GDP growth against real estate returns. The regression equation is 1.25 x nominal GDP growth + 1.9%. Conceptually, this probably represents a cap rate plus growth of capital values slightly higher than economic growth due to supply shortages in certain key locations. We project real estate to return 7.2% annually. One risk to this assumption, however, is that commercial real estate prices are already above the previous peak from 2007; high valuations may dampen future returns. U.S. REITs. We find only weak correlations with direct real estate investment, although REITs have outperformed real estate over time (perhaps because of the inbuilt leverage of REITs). Over time, REITs have become increasingly correlated with equities. We, therefore, use a regression against U.S. equity returns (R2 = 42%), with REIT returns 0.49 x equity returns + 7.7%. This indicates 10.1% annual return from REITs in the long run. U.S. Private equity (PE). In the past, returns from private equity have been 5 or 6 percentage points higher than from public equities. This is most likely due to their higher leverage, bias towards small-cap companies, and stronger shareholder control over the companies they invest in; it can also be thought of as an illiquidity premium. However, it seems likely that excess returns will be lower in future given the bigger size of the PE industry now and relatively high valuations currently. Moreover, the PE industry currently has almost USD 1 Trn in dry power (uninvested capital), a sign that investment opportunities are limited. We assume, therefore, a slightly lower premium over public equities in future of 4 ppts. This results in a total annual return of 9.5%. U.S. Venture capital (VC). Historically (using data since 1986) VC returns have been 0.6 ppts higher than for PE (probably representing a premium for greater risk and smaller size of the companies invested in). We assume 0.5 ppt higher return in future. This leads to a return assumption of 10%. U.S. Structured products. As discussed in the fixed income section above, we use the 20-year average spread over the aggregate bond index of 0.7 ppt. Total assumed return, therefore, is 3.3%. U.S. Farmland. The value of farmland has risen by an average of 4.4% a year since 1920, a period which included five agricultural cycles. We assume that the value of land will continue to rise at the same rate. We think this is a reasonable assumption since, although nominal GDP growth in the U.S. may be lower in future than in the past, global demand for food is likely to continue to grow rapidly. The total return from investment in farm land, using a regression, produces: growth of farm land value x 1.81 + 0.64% = 8.6%. Chart 17Long-Term Commodity Prices U.S. Timberland is more defensive than farmland since trees can be stored "on the stump" and don't need to be harvested each year in the way that crops do even when prices are unattractive. Historically, timberland has returned about 1 ppt less a year than farmland, and we assume that this will continue. Commodities move in long-run cycles, with a commodity super-cycle of around 10 years, in which prices rise by 3-4x, followed by a bear market of 20 or 30 years in which they fall or stagnate (Chart 17). This is driven by a build-up of excess supply, because of the capex done during the super-cycle, and often by a structural shift on the demand side too. We see no reason why this pattern should change, with China's re-engineering of its economy away from dependence on infrastructure spending likely to be a particularly important factor over the next decade. We assume that commodity prices will, over the current bear market (now about five years old), fall by the same amount and over the same number of years as the average of previous bear markets since the 19th century. This means they have 16% further to fall over 200 months, giving a return of -1% a year. 4. Currencies Most investors are unable or unwilling to fully hedge currency exposure over very long periods. So, a consideration of how returns from different countries' assets might be affected by relative currency movements over the next 10-15 years is an important element in calculating likely returns. Fortunately, for developed market currencies at least, there is a simple, and historically fairly reliable, way to make assumptions of currency movements: reversion to purchasing power parity. As shown in Chart 18, major currencies have fairly consistently reverted to their PPP over the long run. So we can forecast likely future currency movements as a combination of 1) how far away the currency is currently from PPP against the U.S. dollar, and 2) the likely change in the PPP over the period. The latter we calculate from the IMF's forecasts of relative consumer inflation between each country and the U.S. (the IMF makes this forecast only for the next five years, but we assume that the differential continues at the same rate after 2022). Table 11 shows that most major currencies are expected to rise against the U.S. dollar over the coming decade or so. Except for Australia, they are likely to have slightly lower inflation. And - again with the exception of Australia - they all look a little undervalued currently relative to the USD. Table 11Assumed Annual Change Versus U.S. Dollar Over Next 10-15 Years Unfortunately, this approach does not work for EM currencies. They have historically traded at a level consistently well below PPP. This is mainly because, while tradable goods prices tend to be driven by international prices movements and relative unit labor costs, local services prices (which cannot be arbitraged across borders) do not. Also, inflation in emerging markets has historically been much higher than in the U.S. (Chart 19), meaning that their PPP has shifted significantly lower over time. However, China's inflation is now not dissimilar to that of the U.S. (the IMF forecasts it will be only 50 basis points a year higher over the coming five years). And China has shown some tendency for the currency to move towards PPP - 20 years ago the RMB was 190% below PPP; now it is "only" 97% below. Chart 18Reversion To PPP Chart 19U.S. And Emerging Market Inflation We, therefore, take an alternative approach to estimating currency returns for EM economies. We run a regression analysis of the annual change in each country's exchange rate versus the U.S. dollar against its CPI inflation relative to the U.S. We find mostly acceptable r-squared scores (ranging from 57% for Turkey to 1% for Taiwan). For most countries, the intercept is positive (suggesting the currency is trending over time towards PPP) and the coefficient for CPI is, as expected, negative (Table 12). Table 12Calculations For EM Currency Moves A number of EM currencies, on this analysis, would be expected to depreciate against the U.S. dollar over coming years, including Indonesia, Mexico and Turkey. But, weighting the countries by their weights in the MSCI ACWI index, on average the EM universe would be expected to see a currency appreciation against the U.S. dollar of around 2% a year. This is largely due to the influence of China, which has a 29% weight in the EM index. This would be a much better result than the past 10 years when, for example, the Brazilian real has depreciated by 12% a year, the Indonesian rupiah by 16% and the Turkish lira by 37%. This could be because the IMF forecasts of future inflation (4.9% for India, 4.5% for Brazil and 4.1% for Russia), are too optimistic. They are certainly much better than these countries have achieved in the past 10 years (8.0% in India, 6.2% in Brazil, and 9.2% in Russia). Conclusion Arriving at assumptions for future returns is as much an art as a science. Our analysis is based principally on the concept that the future will be similar to long-term history (but not necessarily to the history of the past 30 years, which in many ways were abnormal for financial markets with, for example, a continuous decline in interest rates and inflation). Obviously, therefore, a very different macro environment over the next 10-15 years (for example, one in which inflation spiked, or secular stagnation deepened) would produce a very different results for economic growth and interest rates. However, it will be clear from our analysis that a great deal of the long-term return for equities and bonds is derived from the valuation at the start. Given that current valuations in almost all asset classes are expensive relative to history, this implies that future portfolio returns will be poor compared to recent, and long-term, history. Based on our return assumptions, a typical global portfolio (with 50% equities, 30% bonds, and 20% alternatives) will produce a nominal return of only 4.1% a year over the next decade or so, and a similar U.S. portfolio only 4.6%. This compares to 6.3% and 7.0% over the past 20 years. For pension funds which assume an 7.5% or 8% annual return (as many in the U.S. do), or individual investors planning their retirement on the basis of, say, a 5% annual real return, that outcome would come as a nasty shock. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For the best summary of the evidence on this, please see A Practitioner's Guide To Asset Allocation, by William Kinlaw, Mark Kritzman and David Turkington, Wiley 2017. 2 Please see Credit Suisse Global Investment Returns Yearbook 2017 by Elroy Dimson, Paul Marsh and Mike Staunton, February 2017 3 BCA's Composite Valuation Indicator comprises, for the U.S.: market value of equities / non-financial gross value added adjusted for foreign revenues, trailing PE, Shiller PE, and price to sales. And for other regions: divided yield, market Cap/GDP, trailing PE, price to book, forward PE, price to cash flow, price to sales, and enterprise value/total assets. 4 Please see Global Asset Allocation Special Report, "Alternative Assets: More Important Than Ever", dated 11 March 2016, available at gaa.bcaresearch.com Appendix Correlation Matrix

Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve Chart 3Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights A Quick Primer: Convertible bonds have a risk/reward profile that falls somewhere between B-rated and Caa-rated high-yield bonds. The key difference is that convertible bonds are less exposed to credit spreads than junk bonds and more exposed to the equity market. Performance Vs. Junk: Convertibles tend to outperform junk bonds in the late stages of bull markets. Junk spreads tend to trough prior to the peak in equities, and rising Treasury yields also favor convertibles. The Value Proposition: Convertible bonds appear somewhat cheap relative to equities, but equities are fairly valued compared to junk bonds and convertible bonds currently offer an unattractive investment premium. Valuation is by no means compelling, but it should not prevent convertibles from outperforming junk bonds in the late stages of the recovery. Feature From time to time we are asked whether convertible bonds have a place in U.S. fixed income portfolios, and this is the question we consider in today's Special Report. Being a hybrid credit/equity investment, it is clear that convertibles are a fairly high-risk proposition for U.S. bond funds. In fact, we find that the historical risk/reward profile of the sector falls somewhere between B-rated and Caa-rated High-Yield corporate debt (Chart 1). So while not for every investor, we do find compelling reasons for why, in the current macro environment, U.S. bond funds should consider replacing some high-yield debt with an allocation to convertible bonds. Chart 1Fixed Income Universe - Risk Vs. Return* (1990s To Present) This report proceeds as follows. The first section provides a quick primer on convertible bonds, with a focus on the risk factors that drive the sector's performance. The second section takes a look at the historical performance of convertibles in different macro environments. The last section considers valuation in the sector. A Quick Primer Convertible bonds are much like traditional corporate bonds in that they pay periodic fixed coupons and have a maturity date. However, convertibles also give bondholders the option to convert the bond into a pre-specified number of shares of common stock. Investors obviously pay a premium for this option but have the potential to realize large gains if the firm's stock price rises. Convertibles are typically issued by smaller firms with low credit ratings. Fifty percent of the face value of the Bloomberg Barclays U.S. Convertibles index comes from small-cap and mid-cap firms. In addition, 58% of the Convertibles index face value comes from non-rated firms. For comparison, only 0.22% of the Bloomberg Barclays High-Yield bond index is un-rated. Technology firms make up 35% of the Convertibles index, which should not be surprising since the convertibles market appeals to small issuers with large financing demands who may have limited access to traditional debt and equity markets. The Convertibles index also has a large concentration in Healthcare & Pharmaceuticals (19%) and Financials (15%). In contrast, the largest sectors in the High-Yield bond index are Communications (20%), Consumer Cyclicals (15%) and Energy (14%). Chart 2Convertible Bond Value Illustrated The value of a convertible bond is illustrated in Chart 2. This chart shows how the price of a convertible bond (the line labeled "Convertible Bond Value Curve") evolves relative to the firm's stock price (shown on the x-axis). It also helps define a few key terms: Parity: Also called the "conversion value" of the security. This represents the value of the security if the conversion option is exercised. It is the 45 degree line passing through the origin of Chart 2. Conversion Premium: This is the difference between the price of the convertible bond and its parity value. In other words, it is the extra price an investor must pay for a convertible bond relative to simply buying the firm's equity. It can be thought of as the cost of downside protection for an equity investor. Chart 2 shows that this cost is larger when the firm's equity price is low. Investment Value: Also called the "bond floor". This is the value of the security if the conversion option is never exercised. It is the thick dashed line in Chart 2. Investment Premium: This is the difference between the price of the convertible bond and its investment value. In other words, it is the extra price an investor must pay for a convertible bond relative to simply buying a corporate bond. It can be thought of as the cost a convertible bond investor must pay to get potential equity exposure. Chart 2 shows that this cost is greater when the firm's stock price is high. We can use the concepts of conversion premium and investment premium to define three types of convertible bonds. A convertible bond is called "credit sensitive" when its underlying stock price is low. This type of convertible bond is valued very similarly to a corporate bond because there is only a low chance that the conversion option will be exercised. It therefore has a large conversion premium and a small investment premium. Conversely, an "equity sensitive" convertible bond is valued similarly to an equity. This is a convertible bond with an elevated underlying stock price, one that would make it beneficial to exercise the conversion option. These securities have high investment premiums and very low conversion premiums. "Balanced" convertible bonds fall between the other two categories. The stock price has not quite reached the value that makes the conversion option attractive, but it is close enough that the security trades at a significant investment premium. Risk Factors & Performance Drivers Based on the historical risk/reward relationship shown in Chart 1, it is clear that if convertible bonds should be included in U.S. fixed income portfolios it is in place of B-rated and Caa-rated junk bonds. We must therefore consider what factors determine the relative performance between high-yield bonds and convertibles. Chart 3Risk Decomposition, 1999-Present To do that we performed regressions of monthly total returns for both an index of convertible bonds and an index of B-rated and Caa-rated high-yield bonds on three risk factors: Interest rate risk: proxied by the yield on the Treasury Master index Credit risk: proxied by the change in the high-yield bond spread Equity risk: proxied by monthly returns from the S&P 600 The top panel of Chart 3 shows the betas from the regressions. It shows that junk bonds have greater sensitivity to interest rate risk and credit risk, but are less sensitive to equity risk. However, to perform a complete risk attribution we need to consider both the sensitivity of returns to each risk factor and the volatilities of the risk factors themselves. The second panel of Chart 3 shows the variance of each of the three risk factors and the covariance between each pair of risk factors. With that information we are able to calculate the exposure of both junk bond and convertible bond returns to each risk factor by multiplying the squared beta by the variance of each risk factor.1 The results of this complete risk accounting are presented in the bottom panel of Chart 3. It shows that both convertible bond and junk bond total returns have small exposures to interest rate risk, with junk bonds having a somewhat larger exposure. However, the big difference between the two assets is that junk bond returns are mostly determined by credit risk while convertible bond returns are mostly determined by equity risk. This means that we can boil the decision of whether to invest in junk bonds or convertible bonds down to the question of whether junk spreads are likely to outperform equities. It is this question that we address in the next section. Convertible Bond Performance: Equities Vs. Credit Chart 4 shows that the history of relative total returns between convertible and high-yield bonds has gone through five distinct phases since the early 1990s. Chart 4Five Phases Of Convertible Bond Performance In the first phase, which culminated in the 1999/2000 tech boom, convertibles significantly outperformed junk. This is because junk spreads widened while equities performed exceptionally well. The fact that convertible bonds were a popular financing choice for small-cap tech companies also helped the sector's returns in 1999. The second phase, between 2000 and 2005, was characterized by falling Treasury yields and tighter credit spreads. Equities also performed well during this period, but not by enough to offset the impact of falling yields and tighter spreads. Junk bonds outperformed convertibles. Convertibles then outperformed junk from 2005 until the peak of the stock market in 2007. Junk spreads widened prior to the peak in the stock market, and this caused convertibles to outperform junk. Junk outperformed convertibles from 2007 until the mid-2012 trough in Treasury yields. This period was somewhat unique in that both equities and junk spreads were relatively flat. It was the greater impact of falling Treasury yields on junk bonds that drove the relative performance. Finally, convertibles have outperformed sharply since 2012, due to much higher equity prices. Junk spreads are also tighter but did experience a large widening in 2014/15. Higher Treasury yields during this time have also favored convertibles over junk. The Outlook For Convertibles The above framework gives us a way to qualitatively assess whether convertibles are likely to outperform junk going forward. First, with the Fed likely still not passed the mid-point of its rate hike cycle, Treasury yields will probably continue to rise. This will favor convertible bonds over junk bonds. Second, we have previously shown that junk bond spreads are fast approaching historically tight levels.2 In fact, we can calculate that B-rated junk spreads can only tighten another 180 bps before reaching all-time expensive valuations and Caa-rated spreads can only tighten another 375 bps. This represents only four months and five months of average monthly spread tightening, respectively. Further, junk spreads have a history of starting to widen before equity bear markets. The 2008 and 2002 bear markets being the most obvious examples (Chart 4, bottom 2 panels). If this pattern is repeated it will help convertibles outperform junk in the late stages of the current recovery. On the equity side, although valuations are also expensive, prices should continue to rise as long as inflation stays low enough for the Fed to maintain an accommodative policy stance. Our U.S. Investment Strategy service also thinks that small cap equities will outperform large caps in the coming months.3 As discussed above, convertible bonds are mostly issued by small cap firms. Our Cyclical Capitalization Indicator is above the zero line, indicating a favorable macro environment for small caps, and our valuation indicator shows that small caps are relatively cheap (Chart 5). However, arguably more important is that small caps remain a strong high-beta equity play (Chart 5, bottom panel). As long as the equity bull market is maintained, then small caps should outperform. One final factor that should drive the relative outperformance of small cap equities is the potential for Congress to pass tax legislation in the first half of next year. The relative small cap trade has been strongly correlated with other trades that are likely to benefit from proposed tax legislation and right now the market is probably assigning too low a probability to the chance that such legislation will pass (Chart 6). The biggest near-term risk for convertible bond returns relative to junk stems from the Technology sector. Chart 7 shows that divergences in performance between convertible bond sectors and high-yield bond sectors tend to be short lived. It also shows that Technology convertible bonds have strongly outperformed their high-yield counterparts in recent months. It is almost certain that convertible Technology bonds are due for a period of underperformance, much like what happened to Healthcare & Pharmaceutical convertibles in 2014/15 (Chart 7, bottom panel). Given the size of the convertible Technology sector, any period of sector-specific underperformance would also exert a meaningful drag on the overall index. Chart 5Small Caps Poised For Outperformance Chart 6The Trump Trades Are Back On Chart 7Tax Cuts Will Help Small Caps In general, traditional late-cycle dynamics - rising Treasury yields and junk spreads widening before equities sell off - should favor convertible bonds over junk between now and the end of the economic recovery. We expect this will also be the case in the current cycle, although the recent outperformance in the technology sector makes us cautious in the near-term. The best strategy is probably to replace some low-rated high-yield bonds with convertibles, while avoiding the technology sector, and then subbing out even more junk for convertibles once Technology convertibles have come back down to earth. Bottom Line: Convertibles tend to outperform junk bonds in the late stages of bull markets. Junk spreads tend to trough prior to the peak in equities, and rising Treasury yields also favor convertibles. This pattern will likely be repeated in the current cycle, although lofty valuations in the Technology sector make us cautious in the near-term. The Value Proposition The final question worth considering is whether convertible bonds appear fairly valued relative to history and investment alternatives. Specifically, we consider valuation from three different perspectives: Are equities fairly valued relative to high-yield bonds? If equities are cheap relative to high-yield bonds then it is reasonable to expect that convertible bonds are also cheap. Are convertible bonds fairly valued relative to equities? Are convertible bonds fairly valued relative to themselves? To answer the first question we use the BCA S&P 500 Valuation Indicator as our measure of equity valuation (Chart 8, top panel) and the 12-month high-yield breakeven spread as our measure of junk bond valuation (Chart 8, bottom panel). Both indicators are at relatively expensive levels. According to our chosen valuation metrics, equity valuation was only more expensive than it is today during the late 1990s tech boom, but in that period it reached much more expensive levels before changing course. In contrast, there have been several periods when junk breakeven spreads have been tighter, but even the all-time low is not that far below current levels. To create a true relative value indicator we standardized both our equity valuation indicator and the 12-month breakeven junk spread, and then subtracted one from the other. The result is shown in the middle panel of Chart 9 and it suggests that equities look a tad cheap compared to junk. However, relative valuation is nowhere near an extreme, and a more reasonable conclusion would be that equities and junk bonds appear fairly valued relative to each other. Chart 8Equity, Convertible & Junk Valuation I Chart 9Equity, Convertible & Junk Valuation II To answer the second question, whether convertible bonds look cheap relative to equities, we compare the parity (or conversion value) of the Convertible Bond index to our equity valuation indicator. The parity of the Convertible index is shown in the middle panel of Chart 8, and it shows that convertible bonds are quite expensive, but not as expensive as they were between 2013 and 2015. In contrast, our equity valuation indicator is at its most expensive levels of the current cycle. Once again, we standardize both our equity valuation indicator and the Convertible Bond index parity and take the difference. The result is shown in the bottom panel of Chart 9, and unsurprisingly, it suggests that convertible bonds appear relatively cheap compared to equities. To answer the final question, how convertibles are valued relative to themselves, we turn to Charts 10 and 11. Chart 10 shows the conversion premium of the Convertible Bond index relative to its parity. In essence, this chart shows how much extra an investor is being charged for convertible bonds relative to a similar equity portfolio. For a given parity level, a low conversion premium would suggest a more attractive valuation, and vice-versa. At the moment, Chart 10 shows that the index conversion premium is almost exactly in line with its expected value given the level of parity. Chart 10Conversion Premium Vs. Parity Chart 11Investment Premium Vs. Parity Chart 11 shows the Convertible Bond index's investment premium relative to parity. This chart shows how much extra an investor must pay for convertible bonds relative to a similar basket of corporate bonds. Once again, a low investment premium would suggest a more attractive valuation, but at the moment the investment premium appears quite elevated. For the given parity level, investors are paying a bit too much for convertibles relative to a similar basket of corporate bonds. In summary, while convertible bonds do appear somewhat cheap relative to equities, on balance, there is not much of a pure valuation case for the asset class. Equities appear fairly valued relative to junk bonds, and convertibles are trading at an elevated investment premium. We do not think that valuation will be a significant headwind to the typical late-cycle outperformance of convertibles versus junk. Bottom Line: Convertible bonds appear somewhat cheap relative to equities, but equities are fairly valued compared to junk bonds and convertible bonds currently offer an unattractive investment premium. Valuation is by no means compelling, but it should not prevent convertibles from outperforming junk bonds in the late stages of the recovery. Alex Wang, CFA, Research Analyst alexw@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 We also use beta weights to attribute the covariance risk to each individual risk factor and calculate the unexplained risk as the variance of the bond returns less the risk exposure from each of our three factors. 2 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Investment Strategy Weekly Report, "Small Cap Surge", dated October 9, 2017, available at usis.bcaresearch.com

Highlights Chart 1Fed Must Fall Behind The Curve Jerome Powell will assume the Fed Chairmanship at a critical juncture for monetary policy. Core PCE inflation is still well below the Fed's 2% target, and yet, the slope of the 2/10 Treasury curve is a mere 71 bps (Chart 1). Such a flat yield curve alongside such low inflation suggests that the market believes the Fed will tighten the yield curve into inversion before inflation even regains the Fed's target. That would be an unprecedented policy mistake that the new Chairman will seek to avoid at all costs. This means either inflation will soon rise, justifying the FOMC's median rate hike projections, or inflation will stay low and the Fed will be forced to take a dovish turn. Either way the Fed must "fall behind the curve" and start chasing inflation higher. The act of falling behind the inflation curve means that long-maturity TIPS breakevens are likely to widen, the yield curve will steepen and the policy back-drop will stay accommodative for spread product. We recommend positioning for all three of these outcomes. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in October, bringing year-to-date excess returns up to 288 bps. The average index option-adjusted spread tightened 6 bps on the month, and now sits at 97 bps. Two weeks ago we noted that there is simply not much room for investment grade corporate spreads to tighten.1 Looking at 12-month breakeven spreads shown as a percentile rank relative to history, we see that A-rated paper has only been more expensive than it is today 7% of the time. Baa-rated paper has been more expensive only 9% of the time (Chart 2).2 Further, we calculate that at current duration levels Baa-rated option-adjusted spreads can only tighten another 36 bps before the sector is more expensive than it has ever been. Similarly, A-rated spreads can tighten another 14 bps, Aa-rated spreads another 17 bps and Aaa-rated spreads another 7 bps. All this to say that corporate bonds are essentially a carry trade at this stage of the cycle. The important question is how much longer we can pick up the carry before a period of significant spread widening. With low inflation keeping monetary policy accommodative and accelerating profit growth putting downward pressure on leverage (bottom 2 panels), the carry trade appears safe for now (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3B Corporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 51 basis points in October, bringing year-to-date excess returns up to 580 bps. The index option-adjusted spread (OAS) tightened 9 bps on the month, and currently sits at 339 bps. Based on our current forecast for default losses we calculate that, if junk spreads remain flat, high-yield excess returns will be 230 bps for the next 12 months. If spreads tighten by 100 bps we should expect excess returns of 606 bps, and if spreads widen by 100 bps we should expect excess returns of -145 bps (Chart 3). Given that the OAS for the high-yield index can only tighten another 139 bps before it reaches all-time expensive valuations, 606 bps is a fairly optimistic excess return projection. But equally, with inflation pressures still muted and monetary policy still accommodative, more than 100 bps of spread widening is also unlikely. Our base case forecast is that high-yield excess returns will be between 2% and 5% (annualized) on a 6-12 month investment horizon.3 In a recent report we noted that high-yield generally looks more attractive than investment grade after adjusting for differences in spread volatility between the two sectors.4 Specifically, we calculate that it will take 39 days of average spread tightening before B-rated bonds reach all-time expensive levels. The same calculation shows it will take 19 days for A-rated debt. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in October, bringing year-to-date excess returns up to 31 bps. The conventional 30-year zero-volatility MBS spread was roughly flat on the month, as was the option-adjusted spread (OAS) and the compensation for prepayment risk (option cost). Last month we upgraded Agency MBS from underweight to neutral, noting that OAS have become significantly more attractive during the past year, particularly relative to corporate credit (Chart 4). The spread widening likely resulted from the market pricing-in the impact of the Fed's balance sheet run-off. Now that the run-off has begun, and its future pace has been well telegraphed, its impact has probably also been fully priced. While OAS is the correct measure of MBS carry because it adjusts for expected losses due to prepayments, it is the change in the nominal spread that determines capital gains and losses. With that in mind, it is difficult to see a catalyst for significantly wider nominal MBS spreads on a 6-12 month horizon. The two factors that correlate most closely with nominal MBS spreads - credit spreads and mortgage refinancings - are likely to stay depressed (bottom panel). Higher mortgage rates would obviously prevent refinancings from rising. But we showed in a recent report that even if rates move lower the coupon and age distribution of outstanding mortgages has made refi activity much less sensitive to rates than in the past.5 Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to 193 bps. Sovereign bonds underperformed the Treasury benchmark by 5 bps on the month. Foreign and Domestic Agency bonds outperformed by 2 bps and 9 bps, respectively. Supranationals outperformed by 4 bps. The underperformance in Sovereigns was concentrated in Mexican debt, which sold off as the White House took a hard line on NAFTA negotiations. Local Authority bonds outperformed by 62 bps in October, bringing year-to-date excess returns up to 367 bps (Chart 5). Excess returns for Local Authority debt - mostly taxable municipal debt and USD-denominated Canadian provincial debt - have exceeded excess returns from Baa-rated corporate debt so far this year, despite the sector's average credit rating of Aa3/A1. In a recent report we looked at whether USD-denominated Emerging Market Sovereign debt is an attractive alternative to U.S. high-yield corporates.6 We observed that hard currency EM sovereigns and similarly rated U.S. corporate bonds offer almost exactly the same breakeven spread, and also that EM Sovereigns have been getting comparatively cheaper since early last year. Further, we observed that periods when EM Sovereigns outperform U.S. corporates tend to coincide with falling U.S. rate hike expectations, as measured by our 24-month fed funds discounter. At present, our 24-month discounter is at 74 bps, meaning the market expects less than three Fed hikes during the next two years. We anticipate a better opportunity to move into EM Sovereigns once U.S. rate hike expectations have adjusted higher. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 43 basis points in October (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 251 bps, year-to-date. The average Municipal / Treasury (M/T) yield ratio edged down in October and currently sits at 87%, still extremely tight relative to its post-crisis trading range. M/T yield ratios look much more attractive at the long-end of the curve (Chart 6), and we continue to recommend that investors extend maturity within their municipal bond allocations. Congress released its first draft of proposed tax legislation last week, and while it will certainly undergo some changes in the coming months, it appears as though it will not be very negative for municipal bondholders. Crucially, the top marginal personal tax rate remains unchanged at 39.6% and demand for munis should benefit from the removal of other deductions. A reduction of the corporate tax rate to 20% remains a risk, but that will likely be revised higher as the bill is re-written. Fundamentally, state & local government health improved sharply in Q3, with net borrowing likely falling to $157 billion from $211 billion in Q2, assuming that corporate tax revenues are unchanged (Chart 6).7 The rate of growth in state & local tax revenues now exceeds expenditures and that should put further downward pressure on borrowing in the coming quarters. However, a decline in state & local government borrowing is already reflected in historically tight M/T yield ratios. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in October alongside a sharp move higher in the expected pace of Fed rate hikes (Chart 7). The 2/10 Treasury slope flattened 8 bps and the 5/30 slope flattened 7 bps. The upward adjustment in rate hike expectations benefited our recommendation to short the July 2018 fed funds futures contract. That trade is now 13 bps in the money since it was initiated on July 10. Further, the July 2018 contract is still discounting fewer than two rate hikes between now and next July. If two more hikes are delivered by July our trade will earn an additional 5 bps. If three more hikes are delivered it will earn an additional 31 bps. In a recent report we discussed why the Fed must soon "fall behind the curve" on inflation and allow the yield curve to steepen.8 Essentially, unless the Fed starts to chase inflation higher it will soon invert the yield curve without having met its inflation goal. That would be a severe policy mistake. This means that either inflation must start to rise, or the Fed must slow its pace of rate hikes. Both scenarios lead to a steeper yield curve. We continue to position for a steeper curve via a long position in the 5-year bullet versus a short position in the 2/10 barbell. At the moment our model shows the 5-year bullet trading roughly in-line with its fair value, or alternatively that the 2/5/10 butterfly spread is priced for an unchanged 2/10 slope on a 6-month horizon.9 TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 33 basis points in October, bringing year-to-date excess returns up to -99 bps. The 10-year TIPS breakeven inflation rate rose 4 bps on the month but, at 1.86%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. As was pointed out on the front page of this report, the Fed must "fall behind the curve" on inflation if it wants to avoid a policy mistake. Our expectation is that this will occur because inflation will move higher in the coming months. The 6-month rate of change in trimmed mean PCE has already bounced off its lows (Chart 8) and pipeline measures of inflation are soaring (panels 3 & 4). However, even if inflation remains stubbornly low, we think any downside in long-maturity TIPS breakeven rates will prove fleeting. We are approaching an inflection point where if inflation does not rise the Fed will have to adopt a much more dovish policy stance. This should limit any downside in long-dated breakevens. As long as the Fed can maintain interest rates low enough for realized inflation to eventually recover to its target, then we anticipate that long-maturity TIPS breakeven rates will settle into a range between 2.4% and 2.5% by the time that occurs. According to our model, the 10-year TIPS breakeven inflation rate is currently trading in-line with other financial market variables - oil, the trade-weighted dollar and the stock-to-bond total return ratio (panel 2). ABS: Neutral Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in October, bringing year-to-date excess returns up to 81 bps. Aaa-rated ABS outperformed the Treasury benchmark by 10 bps on the month, bringing year-to-date excess returns up to 71 bps. Non-Aaa ABS outperformed the benchmark by 32 bps, bringing year-to-date excess returns up to 176 bps. The index option-adjusted spread for Aaa-rated ABS tightened 5 bps in October and, at 33 bps, it remains well below its average pre-crisis trading range. We continue to favor credit cards over auto loans within Aaa-rated ABS, despite the modest additional spread pick-up available in autos (Chart 9). The main reason is that auto loan net losses have been trending steadily higher for several years while credit card charge-offs are still depressed (panel 4). However, even the credit card space is starting to see rising delinquency rates, albeit off a low base, and banks are tightening lending standards on both auto loans and cards (bottom panel). We expect that tight labor markets and solid income growth will prevent a surge in consumer delinquencies, but these are nonetheless troubling signals that bear monitoring. From a valuation perspective, with the 33 bps OAS offered from Aaa-rated Consumer ABS now only slightly higher than the 29 bps offered by Agency Residential MBS, we advocate a neutral allocation to consumer ABS. Further increases in delinquencies could warrant an eventual downgrade, stay tuned. Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 71 basis points in October, bringing year-to-date excess returns up to 182 bps. The index option-adjusted spread (OAS) for non-agency Aaa-rated CMBS tightened sharply in October, from 74 bps to 65 bps. At current levels it is now one standard deviation below its pre-crisis average (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we view the risk/reward trade-off in non-Agency CMBS as quite unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 34 basis points in October, bringing year-to-date excess returns up to 96 bps. The index OAS for Agency CMBS tightened 6 bps on the month but, at 46 bps, the sector continues to offer an attractive spread pick-up relative to other low-risk spread product. The Aaa-rated consumer ABS OAS is only 33 bps, and the OAS on conventional 30-year Agency MBS is a mere 29 bps. Such an attractive spread pick-up in a sector that benefits from Agency backing is probably worth grabbing. Treasury Valuation Chart 11Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.69% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.67%. The Global Manufacturing PMI increased to 53.5 in October, its highest level in six-and-a-half years. Bullish sentiment toward the dollar also edged higher, but not by enough to prevent the fair value reading from our 2-factor Treasury model from climbing. Last month's fair value reading was 2.65%. The U.S. and Eurozone PMIs continued to trend up, while the Chinese PMI held flat. The Japanese PMI ticked down from 52.9 to 52.8. Most importantly, of the 36 countries we track 34 now have PMIs above the 50 boom/bust line. The global economic recovery has become incredibly broad based, a bearish development for U.S. Treasury yields. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.33%. 1 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 2 We use breakeven spreads to adjust for the changing duration of the index over time. We calculate the 12-month breakeven spread as option-adjusted spread divided by duration. We ignore the impact of convexity. 3 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Update", dated October 10, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Living With The Carry Trade", dated October 17, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve", dated October 24, 2017, available at usbs.bcaresearch.com 9 For further details on our model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-14 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Special Report

Highlights Emerging Market (EM) hard currency debt, both sovereign and corporate, has consistently outperformed the broad global bond index. However, investors should steer clear of always maintaining maximum overweights to EM given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. While global growth will remain supportive of EM credit next year, renewed U.S. dollar strength and a re-convergence to the downside with commodity prices present considerable headwinds. Maintain an underweight stance on EM hard currency debt. Favor DM spread product due to more supportive relative growth trends and valuations. Feature Emerging market (EM) sovereign and corporate debt returns have surged in 2017, returning 9.4% and 7.5%, respectively (Chart 1). Investor interest has been renewed, with the latest IMF Financial Stability Report indicating that non-resident inflows of portfolio capital to EM countries have recovered since early 2016 and reached $205 billion for 2017 through August. Against a backdrop of above-trend global economic growth, monetary policy settings from the major central banks that are still accommodative, and some diminished risks from the world's geopolitical hotspots, the current uptrend for EM debt performance could continue. Nevertheless, we urge caution. We moved to a moderate underweight stance on EM hard currency debt back in August, while at the same time increasing our current recommended overweight to U.S. investment grade (IG) corporate debt on the other side of the trade.1 Even with synchronized global growth boosting both EM export demand and industrial commodity prices, we prefer U.S. credit exposure over EM at this point in the cycle, for several reasons: The massive flow-driven EM rally has resulted in not only outsized returns but stretched valuations, with EM debt spreads now back to post-2008-crisis low (or even through those levels for EM hard currency corporates) without any major improvement in EM fundamentals; The previously reliable correlation between EM debt and commodity prices, a long-time driver of EM performance, has broken down, bullishly, for EM - potentially another sign of flow-driven overvaluation; Growing uncertainty over the near-term China growth outlook raises risks on further gains in industrial commodity demand and EM exports; The USD will appreciate once again on the back of additional Fed interest rate hikes beyond levels currently discounted by markets, which could trigger some reversal of the sharp inflows into EM seen this year. Over a strategic horizon, however, it remains difficult to argue against owning a core structural allocation of EM hard currency debt within global fixed income portfolios, given the higher yields that are typically on offer and the fairly consistent historical outperformance over Developed Market (DM) debt. Although the benefits of EM in a portfolio context are slightly overstated given its skewed risk profile (i.e. fat negative tails) and high correlation with DM spread product, specifically U.S. high-yield corporates (Chart 2). Chart 1How Much Longer Can This Rally Last? Chart 2EM Debt Offers Little Diversification Benefits In this Special Report, we examine the long-term role of EM hard currency debt within a fixed-income portfolio, and re-iterate our case for being underweight EM debt on a cyclical basis. The Long-Run Case For Owning EM Debt: A Moderate Core Allocation Makes Sense It is not a stretch to say that EM debt has become the most important part of global bond portfolios in the 21st century. Having a significant EM allocation at the right time can make a bond manager's year, while having it at the wrong time can end a bond manager's career. But what is the "right" allocation to optimize the long-run contribution to returns in a global fixed income portfolio? To answer this question, we took a look at the historical performance of a global bond portfolio that consisted of both DM and EM debt (sovereign and corporate), looking for the combination that would maximize the risk-adjusted return of the portfolio. In our analysis, we ran calculations for two different time periods as the available index data for EM sovereign debt goes back to 1994, while EM corporate debt indices begin in 2002. For DM debt, we used a single index - the Bloomberg Barclays Global Aggregate - as this has a long history and is a common benchmark used by global bond managers that includes both DM sovereign and corporate debt. Though the sample size of our combined global portfolio is limited due to the shorter history of the EM corporates asset class, the findings generally align with our intuition. On a standalone basis, modern portfolio theory proposes that an individual asset should be included within a portfolio if its excess return divided by its standard deviation is higher than the excess return of the portfolio divided by the portfolio's standard deviation, multiplied by the correlation between the portfolio and the asset. Though the correlation to the DM portfolio from 2004 was fairly high for both assets at over 0.6, when we applied this formula, both EM sovereign and corporate debt warranted an allocation in a standard global fixed-income portfolio. EM sovereign debt scored higher, by offering a considerably better Sharpe ratio with only a minimally higher correlation to DM fixed income. While EM hard currency debt has fairly consistently outperformed the DM benchmark on a 12-month rolling basis, investors must be careful not to simply maintain large positions at all times. Obviously, the majority of fixed-income investors have volatility constraints that impose limits on credit allocations. Additionally, apart from simple volatility measures, EM debt has a "hidden" risk profile when looking at the higher moments of return distributions. Table 1EM Debt Returns Are##BR##Negatively Skewed Both EM sovereign and corporate credit historical returns have exhibited significant negative skewness and excess kurtosis, indicating a much higher-than-normal tendency of experiencing outsized, negative returns (Table 1). This is confirmed through Historical Value-at-Risk (VaR) analysis, where the 5% worst returns far eclipsed those of DM investment grade and government debt. Nevertheless, it is important to view EM from a holistic perspective. For example, an asset with a high standard deviation may be less desirable as a standalone investment, but can be highly beneficial if it enhances overall the returns of a portfolio while also reducing its volatility. We tested these "portfolio effects" of EM debt by creating 21 hypothetical portfolios. We began with a DM-only portfolio (consisting of the Global Aggregate index) and increased the weighting toward EM debt by one percentage point in each portfolio, with the last portfolio having a 20% weighting toward EM. The breakdown within EM was 62% corporates and 38% sovereigns based on the market capitalizations of the relevant benchmark indices. Our calculations indicate that the highest portfolio Sharpe ratio was achieved with a 5% EM debt allocation, which also happens to be the "neutral" weighting of EM debt in the BCA Global Fixed Income Strategy model portfolio benchmark index (Chart 3).2 Global bond investors should hover around this weighting on EM hard currency debt, absent a high conviction view on EM. Chart 3The Optimal EM Hard Currency Debt Allocation Is 5% So while the data suggests that EM hard currency debt warrants a long-term allocation, its beneficial impact on a fixed-income portfolio is at least slightly exaggerated. Portfolio managers are typically seeking out assets that can both improve return and decrease overall volatility, thereby increasing the efficiency of their portfolios. This was not the case with EM debt. In our study, increasing the EM allocation consistently raised both returns and volatility. Chart 4EM/DM Correlations Should Decline In 2018 This lack of diversification benefit is a result of the high correlation between EM hard currency debt and DM fixed income. Currently, the correlation between EM and DM (the Global Aggregate) is 0.90, near the upper end of its range, indicating that diversification benefits over the last year were essentially non-existent (Chart 4). Nevertheless, this relationship clearly exhibits a mean reversion tendency. That EM/DM correlation in recent years has been itself correlated to global growth and monetary policy changes. As we show in Chart 4, our diffusion index of OECD Leading Economic Indicators (LEI) - the number of countries with a rising LEI relative to those with a declining LEI - does tend to lead the EM/DM correlation and is currently pointing to a lower correlation as global growth becomes a little less synchronized in 2018. The same goes for the growth rate of major central bank balance sheets which is already slowing and will decelerate even more in 2018 on the back of a diminished pace of bond buying by the ECB and the Fed runoff of maturing bonds on its balance sheet. The conclusion is this - the EM/DM correlation should decline in 2018 but, as we discuss below, we think that happens through relative underperformance of EM credit. Bottom Line: EM hard currency debt, both sovereign and corporate, has consistently outperformed the broad global index. However, investors should steer clear of always maintaining maximum overweights given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Shorter-Run Case For Owning EM Debt: Will Macro Drivers Remain Supportive? So far in 2017, EM sovereign and corporate debt have been beneficiaries of robust global growth, a declining USD and a decoupling from a broader index of commodity prices. While we expect global growth will remain strong over the medium term, our outlook for the USD is still bullish and there is a risk that commodity prices and EM debt performance re-converge to the downside. Global growth will remain strong. Outside of a major global growth slowdown, which we currently view as a low probability event, a mass flight out of EM assets anytime soon is highly unlikely. Indicators such as the global PMI index, industrial production growth and the OECD leading economic indicator are all booming (Chart 5). Inflation will head higher on the back of rising oil prices, but the increase is likely to be gradual. Importantly, this is happening alongside global monetary conditions that remain generally accommodative, even with the Fed in a tightening cycle. Credit, both DM & EM, has historically performed well against this backdrop, as we discuss in the next section of this report. A renewed upleg in the USD bull market is already underway. The correlation between EM currencies and EM debt performance has recovered after breaking down during 2013-15 (Chart 6). Year-to-date, EM currency strength - the flipside of the weaker U.S. dollar - has been a major driver of EM relative performance. Using the IMF's measure real effective exchange rates based on unit labor costs, the U.S. dollar is fairly valued.3 Neutral valuations suggest that directional market indicators are driving currency movements. As the EM business cycle slows and the Fed ramps up its rate hikes in response to rising inflation, the USD cyclical bull market should resume. Chart 5Robust Global Growth##BR##Is Supportive For EM Chart 6Can EM Ignore Another##BR##Round Of USD Strength? The de-coupling between EM debt and commodity price movements is unsustainable. EM debt has experienced a strong rally since 2016 with only a moderate rise in commodity prices compared to past periods of EM strength. We view this decoupling to be temporary (Chart 7). Many sovereign EM issuers are commodity producers, suggesting that this divergence is unsustainable. EM sovereign and corporate debt will not be able to continue their massive rallies if commodity prices relapse. We maintain a bullish view on oil prices, but there are signals that base metal prices are at risk over the next 6-12 months. Chinese monetary authorities have tightened policy and the resulting sharp slowdown in money supply growth is a worrisome sign for Chinese demand for commodities (Chart 8).4 Chart 7EM-Commodity Divergence##BR##Is Unsustainable Chart 8China Downside Risks For##BR##Industrial Commodity Prices Bottom Line: While global growth will remain supportive of EM credit, currency weakness and a re-convergence with commodity prices present considerable headwinds. EM Debt Performance & The Fed Policy Cycle Chart 9The Fed Policy Cycle As more central banks are shifting to a tightening bias, investors are becoming increasingly concerned over policy normalization and its potential impact on credit market performance. Given the strong historical linkages between EM debt performance and Fed policy changes, the current U.S. tightening cycle looms as a major potential problem for EM assets. We have found it most useful to think about changes in Fed monetary policy and asset market performance in terms of breaking up the Fed policy into four distinct phases (Chart 9).5 These are characterized by both the level of interest rates (whether they are above or below "equilibrium") and the direction of policy changes (whether the Fed is raising or cutting rates):6 Phase 1 - the Fed is hiking while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). Phase 2 - the Fed is hiking or keeping policy on hold while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 3 - the Fed is cutting while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 4 - the Fed is cutting rates while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). For EM sovereign debt where we have index data going back to 1994, there have been four episodes of Phase 1 and three episodes of the other phases. For EM corporate debt, where the index data begins in 2002, there have been two episodes of Phases 1 and 4 and only one occurrence of Phases 2 and 3. We present the excess returns of EM debt relative to other major fixed income classes by phase in Table 2. In the limited sample, EM sovereign debt and corporate debt consistently outperformed the Global Aggregate index and most individual bond classes. However, relative to DM high-yield debt, which has the most comparable risk profile, EM sovereign bonds underperformed in Phase 1 and EM corporate debt underperformed in all phases. Table 2Relative EM Debt Performance Worsens As Fed Policy Tightens Excess returns for both EM debt classes were highest in Phase 4, where the central bank is easing while conditions are stimulative. Similar to other risk assets, EM debt also outperformed in Phase 1, where the central bank is tightening while rates are below equilibrium. This makes sense, as the early stages of monetary tightening typically occur in conjunction with stable, above-trend growth. Liquidity conditions are still stimulative in Phase 1, which provides a substantial tailwind for spread product performance. On the other end of the spectrum, EM debt excess returns were relatively low during Phase 2 and Phase 3, and even negative in the case of EM corporate debt for Phase 3. Surprisingly, EM debt has been less affected by the direction of U.S. interest rates than what we would have expected. Monetary easing in Phase 3 was not enough to substantially boost EM relative returns and tightening in Phase 1 did not derail growth or lift the USD enough for EM debt to underperform. In fact, because EM debt still offers robust excess returns during Phase 1 when the central bank is tightening, while also suffering during Phase 3 during central bank easing, we can conclude that the level of policy rates relative to equilibrium has a greater impact on returns than the direction of rates. The severity of the Global Financial Crisis and the relatively subdued pace of recovery for both growth and inflation led to one of the longest Phase 4s in history. Given the low level of starting yields, indicating a large gap to equilibrium, and the 'gradual' pace of normalization, the current Phase 1 should also last longer than it typically has. This bodes well for all credit sectors, including EM sovereign and corporate debt, if history is any guide. However, there are still reasons to be concerned about the impact of U.S. monetary policy on EM assets next year. If the Fed follows through with the interest rate hikes it is currently projecting - another 100bps in total by the end of 2018 - the funds rate will be much closer to equilibrium. If the U.S. dollar rallies alongside that Fed tightening, as we expect, overall U.S. monetary conditions could end up being much closer to a restrictive level than implied by strictly looking at our Fed Policy Cycle (which only looks at the funds rate to determine monetary conditions). Also, the equilibrium funds rate may now be lower than the levels we are assuming in the Fed Policy Cycle framework, suggesting that policy could turn restrictive more quickly in the current tightening cycle. Bottom Line: The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. Another Reason For Caution: Our EM Corporate Health Monitor The BCA EM Corporate Health Monitor (CHM) is a directional indicator aimed at modeling the path of EM corporate spread movements. Financial data from 220 emerging market companies in over 30 countries is aggregated. Only firms that issue USD-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs we have constructed for DM corporates. The indicator is made up of four financial ratios: profit margins, free cash flow to total debt, liquidity and leverage. Unlike the DM CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and free cash flow to debt combined represent 75% of the EM CHM. The latest available reading is from Q2 2017, showing a large decrease, with the indicator now only barely in 'Improving Health' territory (Chart 10). This has occurred in tandem with EM corporate spreads narrowing to post-crisis lows, leaving EM debt at potentially overvalued levels on a fundamental basis. While this slowdown in the EM CHM is not yet a cause for concern, if this became an extended trend of financial health deterioration, the divergence with EM corporate debt performance would be unsustainable and leave EM corporates highly vulnerable to a correction. Chart 10The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal Bottom Line: Our EM Corporate Health Monitor has declined drastically and is barely in 'Improving Health' territory. This alone is not cause for concern yet, but further deterioration in our Monitor combined with additional credit spread narrowing would be a worrisome divergence. Investment Implications Emerging market debt is facing conflicting forces. While continued robust global growth and accommodative monetary policy provide a substantial tailwind for credit performance, extended valuations, the turn in the USD and a potentially worsening commodities outlook present difficult hurdles for EM to overcome. Given the mixed messages, we prefer owning cyclical credit exposure through DM corporate debt, particularly U.S. investment grade. EM debt yields have collapsed and are expensive relative to DM investment grade debt (Chart 11). Combined with a higher risk profile in EM, elevated valuations indicate that EM sovereign and corporate debt are vulnerable to larger corrections. From a return perspective, the difference in the corporate option-adjusted spreads (OAS) has been an excellent leading indicator for relative total returns (Chart 12). This differential indicates that there is considerable relative upside potential for U.S. investment grade over EM hard currency debt. Additionally, while global growth should support credit-related plays, relative growth dynamics are more supportive of U.S. investment grade because the next phase of the global growth upturn will be driven by DM countries and not EM. The difference between the manufacturing PMIs in the U.S. and EM has historically been a good directional indicator for the spread between U.S. corporate bond spreads and EM debt spreads (Chart 13). The gap between the relative manufacturing PMI readings is at a post-crisis high, and could widen further if EM economies suffer on the back of any pullback in Chinese growth in 2018. Chart 11EM Yields & Spreads Look Full Valued Chart 12Favor U.S. IG Over EM Corporates... Chart 13...Because Of Stronger U.S. Growth What are the risks to our view? Our recommended position would suffer in the event that inflation in the U.S. slows, keeping the Fed on hold and maintaining this year's USD downtrend. Also, if China were to ease up on its policy tightening, industrial commodity prices could strengthen once again. Under these scenarios, EM hard currency debt would likely outperform DM spread product. Bottom Line: Maintain moderate underweight positions in EM hard currency debt. Favor DM spread product (especially U.S. investment grade corporates) due to more supportive relative valuations and growth trends. Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 This “EM versus IG” trade was implemented in both our Emerging Markets Strategy and Global Fixed Income Strategy services. Please see BCA Emerging Markets Strategy Weekly Report, “EM: The Focus Is On Profits”, dated August 16th 2017, available at ems.bcaresearch.com, as well as the BCA Global Fixed Income Strategy Weekly Report, “A Lack Of Leadership”, dated August 22nd 2017, available at gfis.bcaresearch.com. 2 The weighting to EM debt in the Global Fixed Income Strategy model bond portfolio benchmark is based on market capitalizations of all the fixed income sectors we wanted to have in the benchmark, which includes non-investment grade debt like global high-yield corporates. It is reassuring to see that our benchmark weighting is also the desired weighting from a long-run portfolio optimization perspective. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?", dated October 11th, 2017, available at ems.bcaresearch.com. 4 Please see the joint BCA Global Asset Allocation/Emerging Markets Strategy Special Report, "Global Equity Allocation: The Underwhelming Case For EM", dated August 9th 2017, available at ems.bcaresearch.com & gaa.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27th 2014, available at usbs.bcaresearch.com. 6 The equilibrium policy rate is a BCA calculation based on long-run real potential GDP growth and long run inflation expectations.

Special Report

Highlights Emerging Market (EM) hard currency debt, both sovereign and corporate, has consistently outperformed the broad global bond index. However, investors should steer clear of always maintaining maximum overweights to EM given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. While global growth will remain supportive of EM credit next year, renewed U.S. dollar strength and a re-convergence to the downside with commodity prices present considerable headwinds. Maintain an underweight stance on EM hard currency debt. Favor DM spread product due to more supportive relative growth trends and valuations. Feature Emerging market (EM) sovereign and corporate debt returns have surged in 2017, returning 9.4% and 7.5%, respectively (Chart 1). Investor interest has been renewed, with the latest IMF Financial Stability Report indicating that non-resident inflows of portfolio capital to EM countries have recovered since early 2016 and reached $205 billion for 2017 through August. Against a backdrop of above-trend global economic growth, monetary policy settings from the major central banks that are still accommodative, and some diminished risks from the world's geopolitical hotspots, the current uptrend for EM debt performance could continue. Nevertheless, we urge caution. We moved to a moderate underweight stance on EM hard currency debt back in August, while at the same time increasing our current recommended overweight to U.S. investment grade (IG) corporate debt on the other side of the trade.1 Even with synchronized global growth boosting both EM export demand and industrial commodity prices, we prefer U.S. credit exposure over EM at this point in the cycle, for several reasons: The massive flow-driven EM rally has resulted in not only outsized returns but stretched valuations, with EM debt spreads now back to post-2008-crisis low (or even through those levels for EM hard currency corporates) without any major improvement in EM fundamentals; The previously reliable correlation between EM debt and commodity prices, a long-time driver of EM performance, has broken down, bullishly, for EM - potentially another sign of flow-driven overvaluation; Growing uncertainty over the near-term China growth outlook raises risks on further gains in industrial commodity demand and EM exports; The USD will appreciate once again on the back of additional Fed interest rate hikes beyond levels currently discounted by markets, which could trigger some reversal of the sharp inflows into EM seen this year. Over a strategic horizon, however, it remains difficult to argue against owning a core structural allocation of EM hard currency debt within global fixed income portfolios, given the higher yields that are typically on offer and the fairly consistent historical outperformance over Developed Market (DM) debt. Although the benefits of EM in a portfolio context are slightly overstated given its skewed risk profile (i.e. fat negative tails) and high correlation with DM spread product, specifically U.S. high-yield corporates (Chart 2). Chart 1How Much Longer Can This Rally Last? Chart 2EM Debt Offers Little Diversification Benefits In this Special Report, we examine the long-term role of EM hard currency debt within a fixed-income portfolio, and re-iterate our case for being underweight EM debt on a cyclical basis. The Long-Run Case For Owning EM Debt: A Moderate Core Allocation Makes Sense It is not a stretch to say that EM debt has become the most important part of global bond portfolios in the 21st century. Having a significant EM allocation at the right time can make a bond manager's year, while having it at the wrong time can end a bond manager's career. But what is the "right" allocation to optimize the long-run contribution to returns in a global fixed income portfolio? To answer this question, we took a look at the historical performance of a global bond portfolio that consisted of both DM and EM debt (sovereign and corporate), looking for the combination that would maximize the risk-adjusted return of the portfolio. In our analysis, we ran calculations for two different time periods as the available index data for EM sovereign debt goes back to 1994, while EM corporate debt indices begin in 2002. For DM debt, we used a single index - the Bloomberg Barclays Global Aggregate - as this has a long history and is a common benchmark used by global bond managers that includes both DM sovereign and corporate debt. Though the sample size of our combined global portfolio is limited due to the shorter history of the EM corporates asset class, the findings generally align with our intuition. On a standalone basis, modern portfolio theory proposes that an individual asset should be included within a portfolio if its excess return divided by its standard deviation is higher than the excess return of the portfolio divided by the portfolio's standard deviation, multiplied by the correlation between the portfolio and the asset. Though the correlation to the DM portfolio from 2004 was fairly high for both assets at over 0.6, when we applied this formula, both EM sovereign and corporate debt warranted an allocation in a standard global fixed-income portfolio. EM sovereign debt scored higher, by offering a considerably better Sharpe ratio with only a minimally higher correlation to DM fixed income. While EM hard currency debt has fairly consistently outperformed the DM benchmark on a 12-month rolling basis, investors must be careful not to simply maintain large positions at all times. Obviously, the majority of fixed-income investors have volatility constraints that impose limits on credit allocations. Additionally, apart from simple volatility measures, EM debt has a "hidden" risk profile when looking at the higher moments of return distributions. Table 1EM Debt Returns Are##BR##Negatively Skewed Both EM sovereign and corporate credit historical returns have exhibited significant negative skewness and excess kurtosis, indicating a much higher-than-normal tendency of experiencing outsized, negative returns (Table 1). This is confirmed through Historical Value-at-Risk (VaR) analysis, where the 5% worst returns far eclipsed those of DM investment grade and government debt. Nevertheless, it is important to view EM from a holistic perspective. For example, an asset with a high standard deviation may be less desirable as a standalone investment, but can be highly beneficial if it enhances overall the returns of a portfolio while also reducing its volatility. We tested these "portfolio effects" of EM debt by creating 21 hypothetical portfolios. We began with a DM-only portfolio (consisting of the Global Aggregate index) and increased the weighting toward EM debt by one percentage point in each portfolio, with the last portfolio having a 20% weighting toward EM. The breakdown within EM was 62% corporates and 38% sovereigns based on the market capitalizations of the relevant benchmark indices. Our calculations indicate that the highest portfolio Sharpe ratio was achieved with a 5% EM debt allocation, which also happens to be the "neutral" weighting of EM debt in the BCA Global Fixed Income Strategy model portfolio benchmark index (Chart 3).2 Global bond investors should hover around this weighting on EM hard currency debt, absent a high conviction view on EM. Chart 3The Optimal EM Hard Currency Debt Allocation Is 5% So while the data suggests that EM hard currency debt warrants a long-term allocation, its beneficial impact on a fixed-income portfolio is at least slightly exaggerated. Portfolio managers are typically seeking out assets that can both improve return and decrease overall volatility, thereby increasing the efficiency of their portfolios. This was not the case with EM debt. In our study, increasing the EM allocation consistently raised both returns and volatility. Chart 4EM/DM Correlations Should Decline In 2018 This lack of diversification benefit is a result of the high correlation between EM hard currency debt and DM fixed income. Currently, the correlation between EM and DM (the Global Aggregate) is 0.90, near the upper end of its range, indicating that diversification benefits over the last year were essentially non-existent (Chart 4). Nevertheless, this relationship clearly exhibits a mean reversion tendency. That EM/DM correlation in recent years has been itself correlated to global growth and monetary policy changes. As we show in Chart 4, our diffusion index of OECD Leading Economic Indicators (LEI) - the number of countries with a rising LEI relative to those with a declining LEI - does tend to lead the EM/DM correlation and is currently pointing to a lower correlation as global growth becomes a little less synchronized in 2018. The same goes for the growth rate of major central bank balance sheets which is already slowing and will decelerate even more in 2018 on the back of a diminished pace of bond buying by the ECB and the Fed runoff of maturing bonds on its balance sheet. The conclusion is this - the EM/DM correlation should decline in 2018 but, as we discuss below, we think that happens through relative underperformance of EM credit. Bottom Line: EM hard currency debt, both sovereign and corporate, has consistently outperformed the broad global index. However, investors should steer clear of always maintaining maximum overweights given its weak volatility reduction benefits and a much higher-than normal tendency of experiencing outsized, negative returns. Our long-term analysis suggests a structural 5% allocation offers the best risk/reward potential. The Shorter-Run Case For Owning EM Debt: Will Macro Drivers Remain Supportive? So far in 2017, EM sovereign and corporate debt have been beneficiaries of robust global growth, a declining USD and a decoupling from a broader index of commodity prices. While we expect global growth will remain strong over the medium term, our outlook for the USD is still bullish and there is a risk that commodity prices and EM debt performance re-converge to the downside. Global growth will remain strong. Outside of a major global growth slowdown, which we currently view as a low probability event, a mass flight out of EM assets anytime soon is highly unlikely. Indicators such as the global PMI index, industrial production growth and the OECD leading economic indicator are all booming (Chart 5). Inflation will head higher on the back of rising oil prices, but the increase is likely to be gradual. Importantly, this is happening alongside global monetary conditions that remain generally accommodative, even with the Fed in a tightening cycle. Credit, both DM & EM, has historically performed well against this backdrop, as we discuss in the next section of this report. A renewed upleg in the USD bull market is already underway. The correlation between EM currencies and EM debt performance has recovered after breaking down during 2013-15 (Chart 6). Year-to-date, EM currency strength - the flipside of the weaker U.S. dollar - has been a major driver of EM relative performance. Using the IMF's measure real effective exchange rates based on unit labor costs, the U.S. dollar is fairly valued.3 Neutral valuations suggest that directional market indicators are driving currency movements. As the EM business cycle slows and the Fed ramps up its rate hikes in response to rising inflation, the USD cyclical bull market should resume. Chart 5Robust Global Growth##BR##Is Supportive For EM Chart 6Can EM Ignore Another##BR##Round Of USD Strength? The de-coupling between EM debt and commodity price movements is unsustainable. EM debt has experienced a strong rally since 2016 with only a moderate rise in commodity prices compared to past periods of EM strength. We view this decoupling to be temporary (Chart 7). Many sovereign EM issuers are commodity producers, suggesting that this divergence is unsustainable. EM sovereign and corporate debt will not be able to continue their massive rallies if commodity prices relapse. We maintain a bullish view on oil prices, but there are signals that base metal prices are at risk over the next 6-12 months. Chinese monetary authorities have tightened policy and the resulting sharp slowdown in money supply growth is a worrisome sign for Chinese demand for commodities (Chart 8).4 Chart 7EM-Commodity Divergence##BR##Is Unsustainable Chart 8China Downside Risks For##BR##Industrial Commodity Prices Bottom Line: While global growth will remain supportive of EM credit, currency weakness and a re-convergence with commodity prices present considerable headwinds. EM Debt Performance & The Fed Policy Cycle Chart 9The Fed Policy Cycle As more central banks are shifting to a tightening bias, investors are becoming increasingly concerned over policy normalization and its potential impact on credit market performance. Given the strong historical linkages between EM debt performance and Fed policy changes, the current U.S. tightening cycle looms as a major potential problem for EM assets. We have found it most useful to think about changes in Fed monetary policy and asset market performance in terms of breaking up the Fed policy into four distinct phases (Chart 9).5 These are characterized by both the level of interest rates (whether they are above or below "equilibrium") and the direction of policy changes (whether the Fed is raising or cutting rates):6 Phase 1 - the Fed is hiking while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). Phase 2 - the Fed is hiking or keeping policy on hold while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 3 - the Fed is cutting while the fed funds rate is above equilibrium (i.e. monetary conditions are restrictive). Phase 4 - the Fed is cutting rates while the fed funds rate is below equilibrium (i.e. monetary conditions are stimulative). For EM sovereign debt where we have index data going back to 1994, there have been four episodes of Phase 1 and three episodes of the other phases. For EM corporate debt, where the index data begins in 2002, there have been two episodes of Phases 1 and 4 and only one occurrence of Phases 2 and 3. We present the excess returns of EM debt relative to other major fixed income classes by phase in Table 2. In the limited sample, EM sovereign debt and corporate debt consistently outperformed the Global Aggregate index and most individual bond classes. However, relative to DM high-yield debt, which has the most comparable risk profile, EM sovereign bonds underperformed in Phase 1 and EM corporate debt underperformed in all phases. Table 2Relative EM Debt Performance Worsens As Fed Policy Tightens Excess returns for both EM debt classes were highest in Phase 4, where the central bank is easing while conditions are stimulative. Similar to other risk assets, EM debt also outperformed in Phase 1, where the central bank is tightening while rates are below equilibrium. This makes sense, as the early stages of monetary tightening typically occur in conjunction with stable, above-trend growth. Liquidity conditions are still stimulative in Phase 1, which provides a substantial tailwind for spread product performance. On the other end of the spectrum, EM debt excess returns were relatively low during Phase 2 and Phase 3, and even negative in the case of EM corporate debt for Phase 3. Surprisingly, EM debt has been less affected by the direction of U.S. interest rates than what we would have expected. Monetary easing in Phase 3 was not enough to substantially boost EM relative returns and tightening in Phase 1 did not derail growth or lift the USD enough for EM debt to underperform. In fact, because EM debt still offers robust excess returns during Phase 1 when the central bank is tightening, while also suffering during Phase 3 during central bank easing, we can conclude that the level of policy rates relative to equilibrium has a greater impact on returns than the direction of rates. The severity of the Global Financial Crisis and the relatively subdued pace of recovery for both growth and inflation led to one of the longest Phase 4s in history. Given the low level of starting yields, indicating a large gap to equilibrium, and the 'gradual' pace of normalization, the current Phase 1 should also last longer than it typically has. This bodes well for all credit sectors, including EM sovereign and corporate debt, if history is any guide. However, there are still reasons to be concerned about the impact of U.S. monetary policy on EM assets next year. If the Fed follows through with the interest rate hikes it is currently projecting - another 100bps in total by the end of 2018 - the funds rate will be much closer to equilibrium. If the U.S. dollar rallies alongside that Fed tightening, as we expect, overall U.S. monetary conditions could end up being much closer to a restrictive level than implied by strictly looking at our Fed Policy Cycle (which only looks at the funds rate to determine monetary conditions). Also, the equilibrium funds rate may now be lower than the levels we are assuming in the Fed Policy Cycle framework, suggesting that policy could turn restrictive more quickly in the current tightening cycle. Bottom Line: The Fed is still in the early stages of rate normalization. At this point in the Fed policy cycle, where the Fed is hiking rates but monetary conditions are still stimulative, EM hard currency debt has historically performed well both on a relative and absolute basis. Looking ahead, EM returns should begin to suffer in latter half of 2018 as the Fed moves to more restrictive policy stance. Another Reason For Caution: Our EM Corporate Health Monitor The BCA EM Corporate Health Monitor (CHM) is a directional indicator aimed at modeling the path of EM corporate spread movements. Financial data from 220 emerging market companies in over 30 countries is aggregated. Only firms that issue USD-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs we have constructed for DM corporates. The indicator is made up of four financial ratios: profit margins, free cash flow to total debt, liquidity and leverage. Unlike the DM CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and free cash flow to debt combined represent 75% of the EM CHM. The latest available reading is from Q2 2017, showing a large decrease, with the indicator now only barely in 'Improving Health' territory (Chart 10). This has occurred in tandem with EM corporate spreads narrowing to post-crisis lows, leaving EM debt at potentially overvalued levels on a fundamental basis. While this slowdown in the EM CHM is not yet a cause for concern, if this became an extended trend of financial health deterioration, the divergence with EM corporate debt performance would be unsustainable and leave EM corporates highly vulnerable to a correction. Chart 10The BCA EM Corporate Health Monitor Has Rolled Over EM Corporate Health Monitor Is Sending A 'Sell' Signal Bottom Line: Our EM Corporate Health Monitor has declined drastically and is barely in 'Improving Health' territory. This alone is not cause for concern yet, but further deterioration in our Monitor combined with additional credit spread narrowing would be a worrisome divergence. Investment Implications Emerging market debt is facing conflicting forces. While continued robust global growth and accommodative monetary policy provide a substantial tailwind for credit performance, extended valuations, the turn in the USD and a potentially worsening commodities outlook present difficult hurdles for EM to overcome. Given the mixed messages, we prefer owning cyclical credit exposure through DM corporate debt, particularly U.S. investment grade. EM debt yields have collapsed and are expensive relative to DM investment grade debt (Chart 11). Combined with a higher risk profile in EM, elevated valuations indicate that EM sovereign and corporate debt are vulnerable to larger corrections. From a return perspective, the difference in the corporate option-adjusted spreads (OAS) has been an excellent leading indicator for relative total returns (Chart 12). This differential indicates that there is considerable relative upside potential for U.S. investment grade over EM hard currency debt. Additionally, while global growth should support credit-related plays, relative growth dynamics are more supportive of U.S. investment grade because the next phase of the global growth upturn will be driven by DM countries and not EM. The difference between the manufacturing PMIs in the U.S. and EM has historically been a good directional indicator for the spread between U.S. corporate bond spreads and EM debt spreads (Chart 13). The gap between the relative manufacturing PMI readings is at a post-crisis high, and could widen further if EM economies suffer on the back of any pullback in Chinese growth in 2018. Chart 11EM Yields & Spreads Look Full Valued Chart 12Favor U.S. IG Over EM Corporates... Chart 13...Because Of Stronger U.S. Growth What are the risks to our view? Our recommended position would suffer in the event that inflation in the U.S. slows, keeping the Fed on hold and maintaining this year's USD downtrend. Also, if China were to ease up on its policy tightening, industrial commodity prices could strengthen once again. Under these scenarios, EM hard currency debt would likely outperform DM spread product. Bottom Line: Maintain moderate underweight positions in EM hard currency debt. Favor DM spread product (especially U.S. investment grade corporates) due to more supportive relative valuations and growth trends. Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 This “EM versus IG” trade was implemented in both our Emerging Markets Strategy and Global Fixed Income Strategy services. Please see BCA Emerging Markets Strategy Weekly Report, “EM: The Focus Is On Profits”, dated August 16th 2017, available at ems.bcaresearch.com, as well as the BCA Global Fixed Income Strategy Weekly Report, “A Lack Of Leadership”, dated August 22nd 2017, available at gfis.bcaresearch.com. 2 The weighting to EM debt in the Global Fixed Income Strategy model bond portfolio benchmark is based on market capitalizations of all the fixed income sectors we wanted to have in the benchmark, which includes non-investment grade debt like global high-yield corporates. It is reassuring to see that our benchmark weighting is also the desired weighting from a long-run portfolio optimization perspective. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?", dated October 11th, 2017, available at ems.bcaresearch.com. 4 Please see the joint BCA Global Asset Allocation/Emerging Markets Strategy Special Report, "Global Equity Allocation: The Underwhelming Case For EM", dated August 9th 2017, available at ems.bcaresearch.com & gaa.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27th 2014, available at usbs.bcaresearch.com. 6 The equilibrium policy rate is a BCA calculation based on long-run real potential GDP growth and long run inflation expectations.

Dear Clients, Please note there was an error in the Recommend Asset Allocation table published on November 1, 2017. This has now been amended. We apologize for the confusion and any inconvenience it may have caused. Best Regards, Garry Evans Senior Vice President Global Asset Allocation Reflation Trade Returns Recommended Allocation The market mood has shifted remarkably quickly over the past couple of months. The probability of a December Fed rate hike has moved up from 20% in early September to close to 100%, pushing the 10-year Treasury bond yield from 2.0% to 2.4% and causing the trade-weighted U.S. dollar to appreciate by 2%, and Emerging Market equities to underperform. We expect this trend to continue. Global growth continues to surprise to the upside (Chart 1). The softness in U.S. inflation this year is likely to reverse over coming quarters - an argument supported by the New York Fed's new Underlying Inflation Gauge, which indicates that sustained movements in inflation continue to trend higher (Chart 2). This makes it likely that the Fed will move ahead with its forecast three rate hikes in 2018, which the market has not yet priced in (Chart 3) - the implied probability of this is only 10%. Consequently, rates have further to rise: our fair value for the U.S. 10-year Treasury yield currently is 2.7%. And the increasing gap between U.S. and euro zone interest rates suggests that the dollar can appreciate further (Chart 4). All this supports our view that risk assets (equities and corporate credit) should outperform over the next 12 months, with developed government bonds producing a negative return, and emerging markets lagging because of rising rates and the stronger dollar (and a possible slowdown in China, as it focuses on reforming its economy and cleaning up the debt situation). Chart 1Growth Surprising To The Upside Chart 2Underlying Inflation Still Trending Up Chart 3Market Expects Fed To Move Only Slowly Chart 4Rate Gap Suggests Dollar Appreciation The key question, though, is how long this positive scenario can continue. With stock market valuations expensive (Chart 5) and investors fully invested, though not yet euphoric (Chart 6), we are clearly in late cycle. Rising rates could put a dampener on growth. Chart 5 Equities Close To Extremely Overvalued Chart 6Investors Are Fully Invested, But Cautious We find the Fed policy cycle a useful tool for thinking about probable investment returns from different assets (Chart 7). The best quadrant for risk assets is when the Fed is easing and policy is easy (with the Fed Funds Rate below the neutral rate). Currently we are in the bottom-right quadrant (Fed tightening, but not yet in the tight zone), which also has produced attractive returns for equities and credit. But once the Fed Funds Rate (FFR) moves above the neutral rate, returns from risk assets are on average poor and, historically, recession often followed quite quickly. How much longer do we have before Fed policy moves into the top-right quadrant? The Fed's own estimate of the neutral rate, in real terms, is 0.3%. The current real FFR (using core PCE inflation, 1.3%, as the deflator) is -0.17 (Chart 8). This implies that it will take only two further Fed hikes to move into the tight zone, which could happen as soon as March. This is why the outlook for inflation is critical. If, as the Fed forecasts and we also expect, core PCE inflation rises to 2%, it will be another five hikes before policy turns tight - we are unlikely to get there until early 2019. Chart 7The Fed Policy Cycle Chart 8How Far From The Tight Zone? For now, therefore, we continue to recommend an overweight on risk assets and pro-cyclical portfolio tilts. Global monetary policy remains easy and we see no indicators that suggest growth is slowing or that the risk of recession over the next 12 months is rising. The risks to this optimistic scenario (a hawkish Fed, over-eager structural reform in China, provocation from North Korea) seem limited. But we also continue to warn of the possibility of a recession in 2019 or 2020 caused, as so often, by excessive Fed tightening. We see, therefore, the possibility of our turning more defensive somewhere in mid-2018. Equities: We prefer developed over emerging market equities. Rising interest rates and an appreciating dollar will be headwinds for EM. Moreover, Xi Jinping's speech at the Communist Party Congress hinted at supply side structural reforms, overcapacity reduction, and deleveraging efforts. A renewed reform effort could dampen Chinese growth somewhat which, as in 2013-15, would negatively impact EM equities (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which are higher beta, have stronger earnings momentum, and benefit from looser monetary policy. Fixed Income: We expect bonds to underperform over coming quarters, as U.S. inflation picks up and the Fed moves raises rates in line with its "dots". Corporate credit still has some attractions, provided the economic expansion continues. U.S. sub-investment grade bonds, in particular, have an attractive default-adjusted yield, as long as a strong economy keeps the default rate over the next 12 months to the historically low 2% our model suggests (Chart 10). The pick-up in inflation we expect would mean inflation-linked bonds outperform nominal bonds. Chart 9Slowing China Would Hurt EM Equities Chart 10Junk Attractive If Defaults Stay This Low Currencies: The ECB delivered a dovish tapering last month, extending its asset purchases until at least September 2018 and emphasizing that its current low interest rates will continue "well past the horizon of our net asset purchases". Given this, and the gap between U.S. and euro zone interest rates (Chart 4), we expect moderate further euro weakness over coming months. The dollar is likely to appreciate even more against the yen. There are the first tentative signs of inflation emerging in Japan (Chart 11) which, combined with the Bank of Japan sticking to its 0% 10-year JGB target and rising global interest rates, could push the yen to 120 against the dollar over coming months. Commodities: BCA's energy strategists recently revised up their crude oil forecasts on the back of strong demand, a likely extension of the OPEC agreement until at least end-2018, and possible supply disruptions in Iraq, Venezuela and other troubled regions.1 They see inventories continuing to draw down until at least 2H 2018 (Chart 12). Accordingly, they forecast $65 a barrel for Brent and $63 for WTI and flag upside risk to those projections. The outlook for industrial and precious metals, however, is less positive. A stronger dollar and a shift in the growth drivers in China will depress prices for base metals. Rising real interest rates will hurt gold, although we still like precious metals as a long-term hedge. Chart 11First Signs Of Inflation In Japan? Chart 12Oil Inventory Drawdowns Support Higher Price Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Oil Forecast Lifted As Market Tightens," dated 19 October 2017, available at ces.bcaresearch.com GAA Asset Allocation