Global
One way to benefit from the global growth soft-patch is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. Since our Monday inception three days ago, this pair trade is already up 9%. The relative moves in the underlying commodities that serve as pricing power proxies are the key drivers of this share price ratio (top panel). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Meanwhile, global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel). Bottom Line: We initiated a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Please refer to this Monday’s Weekly Report for additional details.
European growth expectations from the July ZEW survey remained stuck at very low levels. This hides a dichotomy. German growth expectations continue to fall significantly while Italian ones are finally rising, thanks to the easing in financial conditions…
Japanese foreign machinery tool orders and German industrial orders are contracting deeply, and have not improved, not even on a rate-of-change basis. Meanwhile, China’s imports of capital goods are contracting at a double-digit pace. Chinese auto sales…
Only in a scenario of a complete collapse in global growth will the Fed cut rates more than what is currently priced in the market. Yet, this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will…
Dear Client, In lieu of next week’s regular report, we will be bringing you a Special Report featuring a no-holds-barred debate over the economic and financial market outlook among three of BCA’s more bullish strategists (Doug Peta, Rob Robis, and yours truly) and three of the more bearish ones (Anastasios Avgeriou, Arthur Budaghyan, and Dhaval Joshi). Best regards, Peter Berezin, Chief Global Strategist Highlights Slowdowns are much more likely to turn into recessions when significant economic and financial imbalances are present. The U.S. does not currently suffer from any of the three major imbalances that have historically heralded recessions – rapid private-sector debt growth; excessive spending in cyclical sectors such as housing, consumer durables, and business capex; or accelerating inflation. Imbalances are larger abroad, but not to the extent that they will trigger a global recession. The combination of ongoing Chinese stimulus and the lagged effect from lower bond yields will lift global growth during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind. Stay overweight global equities relative to government bonds over the next 12 months. A rebound in global growth will push down the U.S. dollar later this year, creating an opportunity to increase exposure to European and EM equities. Feature Global Growth At A Critical Juncture The global economy has clearly slowed since early 2018 (Chart 1). So far, much of the weakness has been confined to the manufacturing sector. However, the service sector has softened as well (Chart 2). Chart 1The Global Economy Has Slowed... Chart 2...Mostly Due To Another Manufacturing Downturn Regionally, the U.S. has held up somewhat better than most other economies. Nevertheless, the ISM manufacturing and nonmanufacturing indices have both declined, with the former now flirting with the 50 line. All recessions begin as slowdowns but not all slowdowns end in recessions. As we discuss below, slowdowns are much more likely to morph into recessions when financial and economic imbalances are elevated. We confine our empirical analysis to the U.S., but discuss the global context later in the report. Three Key Recessionary Imbalances Three imbalances, in particular, have often been present at the outset of U.S. recessions (Chart 3): Chart 3What Makes A Slowdown Degenerate Into A Recession: Imbalances Rapid private-sector debt growth: Rising debt lifts aggregate demand.1 Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks. An unsustainably high level of cyclical spending: Cyclical spending includes business and residential investment, as well as spending on consumer durable goods. If spending on these categories is elevated, there is more scope for it to decline when the economy turns down. High and rising inflation. When inflation rises above the Fed’s comfort zone, the central bank normally needs to raise rates into restrictive territory. Fast debt growth is also often associated with bad lending decisions, which makes economies more vulnerable to adverse shocks. Table 1 shows every episode since 1960 when the U.S. economy has slowed significantly. To keep things simple, we define a slowdown as a 10-point drop in the ISM manufacturing index from its recent high. Table 1Episodes Of Significant Economic Slowdown Of the 15 slowdowns that we examined, seven culminated in recessions. An average of 2.1 of the three imbalances listed above were visible prior to recessions. However, an average of only 0.9 imbalances were present when a recession failed to materialize. This supports our claim that slowdowns are more likely to turn into recessions when significant imbalances are present. The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions. Equities reacted very differently in the two cases. When a recession did occur following the start of a slowdown, the S&P 500 declined by an average of 3.6% over the subsequent 12 months. When the slowdown failed to turn into a recession, the S&P rose by an average of 18.3%. In the latter case, the recovery in stocks usually coincided with a swift rebound in the ISM index. The U.S. Is Currently 0 For 3 On The Imbalance Front The good news for the U.S. is that it currently does not register any of three imbalances that have typically preceded recessions. Chart 4Reasons Not To Panic About U.S. Corporate Debt (I) Private-Sector Debt While U.S. private nonfinancial debt has edged up slightly as a share of GDP since 2015, it remains well below its 2008 peak. In fact, the current business expansion is the only one in the post-war era where private-sector debt has failed to rise above its previous cycle high. A recent Bank of England study examined 130 recessions across 26 countries. It found private debt growth matters much more for recession risk than the level of debt.2 Granted, the composition of debt also matters: While household debt in the U.S. has fallen over the past decade, corporate debt has risen. As a share of GDP, corporate debt is now at the highest level in the post-war era. That said, despite its recent ascent, the ratio of corporate debt-to-GDP is less than two percentage points higher than it was in 2008. One drawback of comparing debt to GDP is that the former is a stock variable while the latter is a flow variable. A more sensible “apples-to-apples” approach is to look at corporate debt in relation to assets rather than GDP. If one does that, one sees that the ratio of U.S. corporate debt-to-assets is below its post-1980 average and only slightly above its post-1950 average. The interest coverage ratio, which compares the profits that companies earn for every dollar of interest that they pay, is above its historic norm (Chart 4). Corporate sector free cash flow – the difference between profits and spending on such things as labor and capital goods – remains in surplus. Every recession during the past 50 years has begun when the free cash flow balance was in deficit (Chart 5). In contrast to mortgages, which are generally held by leveraged institutions such as banks, most corporate debt is held by entities such as insurance companies, pension funds, mutual funds, and ETFs. Banks hold only 18% of corporate debt, down from 40% in 1980 (Chart 6). Thus, while high corporate debt levels could exacerbate the next recession, they are unlikely to engender it. Chart 5Reasons Not To Panic About U.S. Corporate Debt (II) Chart 6Banks Have Reduced Their Exposure To The Corporate Sector Cyclical Spending Unlike a restaurant meal or a vacation, a house, office tower, factory, or automobile will usually retain some value for a while after it is purchased. If spending on cyclical items rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. By contrast, if spending on these items is subdued for a long time, pent-up demand will accumulate, requiring a period of higher production. Recessions can result from either economic overheating or financial market overheating. As a share of GDP, cyclical spending is still far below the peaks observed during past expansions. Just as importantly, today’s low level of cyclical spending follows ten years of even lower spending. As a result, the average age of the U.S. capital stock has increased across almost all categories since 2008 (Chart 7). Most notably, the average age of U.S. homes has risen by nearly five years since 2006, the sharpest increase since the Great Depression. Despite the rebound in residential investment from its recessionary lows, the current level of homebuilding still falls short of what is necessary to keep up with household formation. As a consequence, the vacancy rate has fallen to multi-decade lows (Chart 8). Chart 7The Capital Stock Is Aging Chart 8There Is No Glut Of U.S. Homes Inflation Recessions can result from either economic overheating or financial market overheating. Economic overheating was the dominant driver of recessions between the late 1960s to early 1980s. Rising inflation preceded the recessions of 1969-70, 1973-75, as well as the back-to-back recessions in 1980-82. Chart 9The 1990 Recession: A Bit Of Everything Overheating also contributed to the 1990 recession. After peaking in 1982, the unemployment rate fell to 5% in 1989, about one percent below its equilibrium level at the time. Core inflation began to accelerate, reaching 5.5% by August 1990. The Fed initially responded to the overheating economy by hiking interest rates. The fed funds rate rose from 6.6% in March 1988 to a high of 9.8% by May 1989. By the summer of 1990, the economy had already slowed significantly. Commercial real estate, still reeling from the effects of the Savings and Loan crisis, weakened sharply. Defense outlays continued to contract following the collapse of the Soviet Union. The final straw was Saddam Hussein’s invasion of Kuwait, which caused oil prices to surge and consumer confidence to plunge (Chart 9). In contrast to earlier downturns, the last two recessions were more the byproduct of financial excesses: The 2007-09 recession stemmed from the housing crash and the financial crisis it generated; the 2001 recession followed the dotcom bust, which precipitated a steep decline in capital spending. What will the next U.S. recession look like? Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. The fact that the Fed has adopted a risk-based approach to monetary policy, which puts great weight on avoiding a deflationary outcome, only raises the likelihood that inflation will eventually move higher. The good news is that this is unlikely to happen anytime soon. While wage growth has picked up, productivity growth has risen even more. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 10). Given the absence of major financial imbalances, the odds are high that the next recession will be a “retro recession,” featuring classic economic overheating. As we discussed in our latest Strategy Outlook, the Fed will probably not bring rates into restrictive territory until early 2022. This gives the economy plenty of breathing space.3 The Global Dimension The discussion above has focused on the United States. To some extent, this is unavoidable. Not only is the U.S. still the world’s largest economy, but it remains at the heart of the global financial system. U.S. equities account for over half of global stock market capitalization, up from a third in the early 1990s (Chart 11). The dollar continues to be the preeminent reserve currency. As a result, U.S. financial markets drive overseas markets much more than the other way around. Chart 10No Imminent Threat Of A Wage-Price Inflationary Spiral Chart 11The U.S. Stock Market Capitalization Is More Than Half Of Global This does not mean that the rest of the world is irrelevant. The global supply chain now dominates international trade. More than half of all cross-border trade is in intermediate goods (Chart 12). Irrespective of the financial and economic imbalances discussed above, a full-blown trade war would upend the global economy, sending the U.S. and the rest of the world into recession. President Trump’s re-election prospects would plummet if U.S. unemployment rose and the stock market plunged. This is the main reason for thinking that the trade talks will ultimately produce some sort of détente. Nevertheless, a severe deterioration of trade relations remains the biggest risk to our bullish view on risk assets. The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. Unlike in the United States, private debt has risen sharply as a share of GDP in several key economies over the past decade (Chart 13). Government debt is also a problem in countries such as Italy that do not have central banks which can function as reliable lenders of last resort. Chart 14Economies With Frothy Housing Markets Risk Having Deeper Downturns Cyclical spending is fairly elevated in a number of countries. Notably, residential investment stands at near record highs as a share of GDP in Canada, Australia, and New Zealand (Chart 14). Home prices are also quite frothy there. When the global economy falls into recession in two-to-three years, these economies will take it on the chin. Investment Conclusions Notwithstanding the risks noted above, we continue to maintain a bullish outlook on global equities and spread product over the next 12 months. To paraphrase Wayne Gretzky, one should invest on the basis of where the economic data is going, not where it is.4 While global growth remains anemic today, the combination of Chinese stimulus and the lagged effect from lower bond yields will boost activity during the coming months. The inventory cycle, which is likely to subtract at least one full percentage point from U.S. growth in Q2, will also turn from being a headwind to a tailwind. Global equities are not super cheap, but they are not particularly expensive either. The MSCI All-Country World Index trades at 15.3-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 15). From an asset allocation perspective, one should favor stocks over bonds when the ERP is high. Chart 15AEquity Risk Premia Remain Elevated (I) Chart 15BEquity Risk Premia Remain Elevated (II) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13.3-times forward earnings, but it also reflects the fact that bond yields are lower overseas. The fact that financial and economic imbalances are generally larger overseas means that the rest of the world is more vulnerable to adverse shocks. As global growth accelerates, the dollar will start to weaken (Chart 16). EM and European equities usually outperform the global benchmark in that environment (Chart 17). We expect to upgrade stocks in these regions later this summer. Chart 16The Dollar Is A Countercyclical Currency Chart 17EM And Euro Area Equities Outperform When Global Growth Improves Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 2 Jonathan Bridges, Chris Jackson, and Daisy McGregor, "Down in the slumps: the role of credit in five decades of recessions," Bank Of England Staff Working Paper No. 659, (April 2017). 3 Please see Global Investment Strategy Strategy Outlook, "Third Quarter 2019 Strategy Outlook: The Long Hurrah," dated June 28, 2019. 4 According to Wayne Gretzky, his father, Walter, once advised him to “skate to where the puck is going, not to where it is.” Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights Q2/2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -19bps in the second quarter of the year. Winners & Losers: Our below-benchmark overall duration stance expressed through country underweights in the U.S. (-25bps) and Italy (-10bps) hurt Q2 returns. This dwarfed the gains from U.S. corporate bond overweights (+14bps) and selective sovereign bond overweights in Germany, Australia and the U.K. Scenario Analysis For Next Six Months: We are adding credit exposure to our model portfolio, increasing spread product allocations in U.S. high-yield and European corporates. In our Base Case scenario, the Fed is likely to deliver some “insurance” rate cuts in the next few months, but by less than the markets are currently discounting, while global growth momentum will stabilize. The resulting price action will favor relative returns from spread product versus government debt. Feature The first half of 2019 produced a surprising result across the global fixed income universe – practically everything delivered a positive total return. From U.S. Treasuries to Italian BTPs to U.S. investment grade industrial corporates to emerging market hard currency sovereigns, all the year-to-date returns are colored green on your Bloomberg screen. Those returns have occurred despite all the uncertainties that investors have had to navigate during the past three months, from shock Trump tariff tweets to persistent weakness in global manufacturing data to swift dovish turns by global central bankers (rate cuts in Australia and New Zealand, the Fed hinting at easing and the ECB signaling a potential restart of asset purchases). In this report, we review the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful second quarter of 2019. We also present our updated scenario analysis, and total return projections, for the portfolio over the next six months. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2019 Model Portfolio Performance Breakdown: Credit Overweights Help Limit Damage From Below-Benchmark Duration Chart of the WeekBelow-Benchmark Duration Overwhelms Credit Overweights In Q2/19 The total return for the GFIS model portfolio (hedged into U.S. dollars) in the second quarter was 2.8%, underperforming the custom benchmark index by -19bps (Chart of the Week).1 The bulk of the underperformance came from the government bond side of the portfolio (-33bps) - a function of our below-benchmark duration tilt and underweight stance on sovereign bonds, both occurring against a backdrop of rapidly falling bond yields (Table 1). Partially offsetting that was the outperformance from our recommended overweights in U.S. corporate debt, which helped the spread product side of our model portfolio outperform the benchmark by +14bps. Table 1GFIS Model Bond Portfolio Q2/2019 Overall Return Attribution The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. investment grade industrials (+5bps) Overweight U.S. high-yield Ba-rated (+4bps) Overweight U.S. high-yield B-rated (+4bps) Overweight U.S. investment grade financials (+2bps) Overweight German government bonds with maturity of 7-10 years (+2bps) Biggest underperformers Underweight U.S. government bonds with maturity beyond 10+ years (-10bps) Underweight Italy government bonds with maturity beyond 10+ years (-6bps) Underweight Japanese government bonds with maturity beyond 10+ years (-6bps) Underweight U.S. government bonds with maturity of 1-3 years (-5bps) Underweight U.S. government bonds with maturity of 3-8 years (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2019. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q2/2019 (red for underweight, blue for overweight, gray for neutral).2 Ideally, we would look to see more blue bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Our underweight tilts on European Peripheral sovereign debt were our biggest “miss” in the quarter, as Spanish and Italian yields plunged after the ECB signaled future rate cuts and a potential return to bond purchases in order to boost flailing European growth. We had been viewing Spain and Italy as growth-focused credit stories rather than yield plays, leaving us to maintain a cautious stand on both markets given worsening economic momentum (but with an imbedded “long Spain/short Italy” tilt by having a smaller relative underweight in Spain). In terms of our best “hits” in the quarter, our overweight stance on U.S. investment grade corporates and Australian government bonds performed relatively well. We also avoided a big “miss” by upgrading emerging market U.S. dollar-denominated sovereign debt to neutral from underweight on April 30.3 We also avoided a bigger hit to the portfolio through tactical adjustments made in late May, when we added back some interest rate duration to the portfolio given the increasing uncertainties from slowing global growth and rising U.S. trade policy hawkishness.4 We also reduced our U.S. corporate bond overweights at the same time, but the additional duration exposure was the more important factor – without those changes, the portfolio would have lagged the benchmark index by another -8bps in Q2. In terms of our best “hits” in the quarter, our overweight stance on U.S. investment grade corporates and Australian government bonds performed relatively well. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index in the second quarter of the year, with the drag on performance from underweight exposure to U.S. Treasuries and Italian BTPs overwhelming the gains from credit overweights in the U.S. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will be driven by two main factors: our below-benchmark duration bias and our overweight stance on global corporate debt versus government bonds. In terms of the specific high-level weightings in the model portfolio, we currently have a moderate overweight, equal to three percentage points, on spread product versus government debt (Chart 5). This reflects a more constructive view on future global growth, with early leading economic indicators starting to bottom out to the benefit of growth-sensitive assets like corporate debt. That faster growth backdrop will also benefit our below-benchmark duration stance through a rebound in government bond yields. This should happen only slowly, however, as global central bankers are likely to keep their newly-dovish policy bias in place for some time until there are more decisive signs of accelerating growth AND inflation. Chart 6Overall Portfolio Duration: Below-Benchmark We are maintaining our below-benchmark duration tilt (0.5 years short of the custom benchmark), but we recognize that the underperformance from duration seen in the first half of 2019 will only be clawed back slowly over the next six months (Chart 6). As for country allocation, we continue to favor regions where looser monetary policy is most likely (core Europe, Australia, Japan and the U.K.). We are staying underweight the U.S., however, as the market’s expectations for the Fed are too dovish, with -82bps of rate cuts now discounted over the next twelve months. We are also keeping our underweight stance on Italian government bonds, which we now see as overvalued after the recent rally. We are maintaining our below-benchmark duration tilt (0.5 years short of the custom benchmark), but we recognize that the underperformance from duration seen in the first half of 2019 will only be clawed back slowly over the next six months We are, however, making some adjustments to the portfolio allocations to reflect our expectation of less negative news on global growth and easier monetary policies from global central bankers facing uncertainty alongside too-low inflation expectations: Increasing the overweight to U.S. high-yield corporates, boosting the allocation to Ba-rated and B-rated credit tiers by one percentage point each. This is funded by reducing our U.S. Treasury allocation by two percentage points. Upgrading euro area corporates to overweight, increasing the allocation to both investment grade and high-yield by one percentage point each. This is funded by reducing our German government bond allocation by two percentage points. Upgrading U.K. investment grade corporates to neutral, funded by reducing U.K. Gilt exposure by 0.5 percentage points. Upgrading Spanish government bonds to neutral, funded by reducing German exposure by 0.3 percentage points. These changes will boost the overall spread product allocation to 50% of the portfolio (an overweight of seven percentage points versus the benchmark index). This will also boost the overall yield of the portfolio to 3.2%, +6bps greater than that of the benchmark. That relative yield advantage looks even better in U.S. dollar terms, with currency hedging adding an additional +16bps to the relative portfolio yield given the current powerful carry advantage of the greenback (Chart 7). Chart 7Portfolio Yield: Small Positive Carry Chart 8Portfolio Risk Budget Usage: Cautious Even though we have decent-sized overall tilts on global duration and spread product allocation, our estimated tracking error (excess volatility of the portfolio versus its benchmark) remains low (Chart 8). We remain comfortable with a portfolio tracking error of 38bps, well below our self-imposed 100bps ceiling, as the internal weightings in the portfolio are helping keep overall portfolio volatility at a modest level. Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.5 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. In Tables 3A & 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, are all driven by what we believe will be the most important driver of market returns over the rest of 2019 – the momentum of global growth and the path of U.S. monetary policy. Our Base Case: the Fed delivers -50bps of easing by the end of 2019, the U.S. dollar depreciates by -3%, oil prices rise by +10%, the VIX index hovers around 15, and there is a mild bear-steepening of the U.S. Treasury curve. This is a scenario where the Fed delivers a rate cut in July and one more “insurance cut” before year-end, while signaling that no other easing beyond that. The model bond portfolio is expected to beat the benchmark index by +57bps in this case. Global Growth Rebounds: the Fed stays on hold to year-end, the U.S. dollar is flat, oil prices increase +10%, the VIX index falls to 12 and there is a mild bear-flattening of the U.S. Treasury curve. This is a scenario where improving economic data outside the U.S. diminishes the fears of a U.S. recession, allowing the Fed to stand pat and keep rates unchanged as financial market volatility stays muted. The model bond portfolio is expected to outperform the benchmark by +50bps here. Global Downturn Intensifies: the Fed cuts the funds rate by -75bps by year-end, the U.S. dollar falls by -5%, oil prices decline -15%, the VIX index increases to 30 and there is a bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth momentum continues to fade, prompting the Fed to deliver a series of curve-steepening rate cuts to try and stabilize elevated financial market volatility amid increasing recession risks. The model portfolio will severely underperform the benchmark by -41bps with this outcome. The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the U.S. dollar and the VIX index) are different than what was presented in our last model bond portfolio review in mid-April (Chart 9). Then, we were contemplating scenarios involving the Fed keeping rates stable and even potentially looking for an opportunity to deliver another rate hike by year-end. Now, given the Fed’s clear dovish shift after the downshift in global growth momentum, two of our three main scenarios involve rate cuts in the U.S. The only scenario where Treasury yields can fall further, however, is if the global economic downturn deepens – a scenario we view as more of a tail risk rather than a higher-probability possibility (Chart 10). Chart 9Risk Factors Assumptions For The Scenario Analysis Chart 10U.S. Treasury Yield Assumptions For The Scenario Analysis In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. Bottom Line: We are adding credit exposure to our model portfolio, increasing spread product allocation in U.S. high-yield and European corporates. In our Base Case scenario, the Fed is likely to deliver some “insurance” rate cuts in the next few months, but by less than the markets are currently discounting, while global growth momentum will stabilize. The resulting price action will favor spread product over government bonds, helping boost the returns of our model portfolio. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Note that sectors where we made changes to our recommended weightings during Q2/2019 will have multiple colors in the respective bars in Chart 4. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “It’s Time To Break Out The Fine China”, dated April 30, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “The Message From Low Bond Yields”, dated May 28, 2019, available at gfis.bcaresearch.com. 5 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns