Global

Highlights The first quarter is in the books, … : Risk may have been out in the fourth quarter, but it is squarely back in fashion so far this year, with equities and high yield posting gaudy first-quarter returns. … and events have compelled us to modify our high-conviction Fed call, … : There may yet be another four or more rate hikes, but they’re not going to occur this year. … but we’re still confident in our asset-allocation recommendations, … : The Fed may no longer be a menacing presence, but that doesn’t mean Treasuries and longer-maturity bonds are going to have it easy from here. … which should benefit from a more accommodative monetary policy outlook: Conditions remain favorable for equities and spread product, and unfavorable for Treasuries, even if the underlying drivers have shifted. Feature Table 1Whipsaw Newton’s Third Law holds that for every action there is an equal and opposite reaction. Markets have been busy supporting the theorem, as the fourth quarter’s sharp selloff has been nearly erased by the potent first-quarter rally (Table 1). Risk assets have been on a rollercoaster ride, though our economic outlook has been more or less unchanged. We chalked up the fourth quarter’s selloff to fears that the Fed was threatening the expansion. Conversely, the first quarter’s snapback likely owed quite a bit to the Fed’s pivot. By shifting its emphasis from trying to prevent inflation from getting away on the upside to trying to keep inflation expectations from falling too far, the Fed has gone from removing the punch bowl to promising to keep it full. In financial markets, risk assets should be the biggest relative beneficiaries. The Fed’s turn thwarted our more-hikes-than-expected call, at least in the near term. That surprise has been compounded by the administration’s seeming intent to pack the board of governors with nominees chosen solely on the basis of their uber-dovishness, and has inspired us to reflect on our calls. We like to share our reflections, as well as the internal BCA discussions and the client questions that shed light on our views. This week’s report examines some of the most important issues on our minds, and the minds of our colleagues and clients. Q: What does the Fed do from here? The quarterly summary of economic projections compiles FOMC meeting participants’ expectations for the likely path of key economic indicators (real GDP growth, unemployment and inflation) and monetary policy. The latest release revealed that Fed governors and regional presidents sharply dialed back their rate hike expectations between the December meeting and the March meeting (Chart 1). The median participant lopped 50 basis points (“bps”) off of his/her year-end 2019 and terminal fed funds rate projections, calling for no hikes in 2019 and just one more for the current cycle, in 2020. The rationale is a bit of a mystery, as the median participant’s estimates of GDP and inflation only came down modestly, and his/her unemployment rate estimates only rose modestly. It made sense for the Fed to turn away from the gradual pace of hikes it pursued in 2017 and 2018 in response to the sharp tightening in financial conditions brought on by the fourth-quarter selloff. The ensuing rallies in equities and high-yield bonds have undone much of that tightening, however. From a data perspective, it seems the Fed is mostly holding off to see how the outlook for the rest of the world evolves. The minutes of the March meeting, released last week, suggested that there may be more nuance to the Fed’s embrace of patience than markets initially perceived. The money markets had been calling for a 25-bps cut in the fed funds rate, to 2.25%, by the end of 2020; following the March meeting, they swiftly moved to price in a high likelihood of a second cut, to 2% (Chart 2). That outlook does not exactly accord with the committee’s more measured take: “Several participants observed that the [‘patient’] characterization … would need to be reviewed regularly[.] … A couple of participants noted that the ‘patient’ characterization should not be seen as limiting the Committee’s options[.] … Several participants noted that their views of the appropriate target range for the federal funds rate could shift in either direction[.] … Some participants indicated that if the economy evolved as they currently expected, … they would likely judge it appropriate to raise the target range … modestly later this year[.]” Chart 2... To Keeping It Full We continue to believe that the Phillips Curve is alive and well inside the Fed’s policy framework. The inverse relationship between inflation and unemployment is embedded in its macroeconomic models, and will compel the Fed to tighten policy in response to an unemployment rate that is nosing around 50-year lows (Chart 3). With the committee seemingly willing to let inflation get a bit of a head start before it tightens policy, it may well have to hike faster, and establish a higher terminal rate, than it otherwise would have if it had continued to follow a steady course. We believe the tightening cycle has been postponed rather than truncated, contrary to the money market’s view. Chart 3Sixties Flashback Bottom Line: The Fed is not going to take the fed funds rate to 3.25 - 3.5% by year end, as we expected late last year. We still believe the terminal rate is in that neighborhood, however, and the longer the Fed cools its heels, the greater the potential that it could exceed our estimate. Q: What is the outlook for the rest of the world? The March minutes revealed that conditions in the rest of the world continue to influence the Fed’s policy decisions. The slowdown in China, the uncertain outcomes of ongoing trade talks and Britain’s separation from the EU shadow the outlook in emerging economies and the major non-U.S. developed economies. The outlook for China, other emerging markets, and Europe have been a spirited subject of discussion within BCA. With a majority of the managing editors perceiving the signs of some green shoots, we upgraded Chinese equities to overweight from equal weight, and European and EM equities to equal weight from underweight, at our monthly View Meeting last week. An end to China’s deleveraging campaign may be all the rest of the world needs to show a little more life. Chart 4As China Goes China is a critical influence on our global view. We expect that policymakers have already begun de-emphasizing their deleveraging campaign, as suggested by March’s credit data, released Friday, and will encourage lenders to lend. No one at BCA expects a stimulus campaign on the order of the massive 2008 and 2016 efforts, but the general view is that policymakers can take steps to end the deceleration in China’s growth, since it was rooted in their deleveraging drive. The deceleration weighed on trade and manufacturing activity around the world (Chart 4), and may have been the catalyst for the global mini-slowdown. The rest of the world should benefit from the easing in financial conditions driven by the global equity rally. The decline in bond yields has also helped ease financial conditions, and the nearly unanimous dovishness of major-economy central banks may provide investors and consumers with additional comfort. The key issue for the U.S. economy, and U.S.-oriented investors, is whether or not the other major economies will slow enough to cool off the U.S. at a time when its fiscal impulse is slowing. We have a sense that China and Europe are beginning to turn, and we do not expect spillovers to drag on U.S. growth, but continued rallies in U.S. risk assets probably require some sort of revival beyond its shores. Q: How do corporate profits look? Is the consensus overly optimistic? The corporate profit outlook is getting less ambitious by the day. Over the last three months, consensus expectations for first quarter S&P 500 share-weighted earnings have fallen by 6.5%, as analysts downwardly revised their year-over-year growth projections from +3.5% to -2.2%. Management teams seek to under-promise and over-deliver, and do their best to guide analyst expectations to a level their companies can exceed. Since 1994, according to Thomson Reuters, about two-thirds of companies have reported earnings that beat estimates. On average over that stretch, companies have beaten estimates by a margin of 3.2%. We are therefore inclined to take the projected earnings contraction with a grain of salt. Corporations seem to have lowered the bar to a level they should be able to clear without too much trouble. Chart 5Wages Aren't Yet Pressuring Margins ... We are further inclined to question the projected 2.2% contraction in earnings, given that revenues are projected to grow by 5% in the quarter. The disparity implies margin contraction of close to 7%. Compensation is the largest component of corporate expenses, with the remainder roughly split between interest expense and other input costs. The other meaningful input is the dollar, which should most often exhibit an inverse relationship with margins. Real unit labor costs is the compensation series that most directly impacts profit margins, and it has been contracting on a year-over-year basis, augmenting margins (Chart 5). It will continue to do so as long as nominal wage growth lags inflation and productivity gains. BBB-rated corporate yields were materially higher in the first quarter than they were a year ago, and may have taken a modest bite out of margins, but they’re now back to where they were then and cannot explain the projected 7-ppt margin haircut by themselves (Chart 6). Producer prices grew just 2.2% on a year-over-year basis, slightly ahead of consumer prices (Chart 7), suggesting that margins only slightly narrowed from the disparity between input costs and selling costs. Chart 6... And Interest Rates Aren't Anymore Chart 7Input Costs Are Manageable The broad trade-weighted dollar gained 6% from 1Q18 to 1Q19. Assuming corporations lower prices to defend market share against foreign competitors, profit margins should fall when the dollar rises. Dollar appreciation likely exerted some incremental pressure on margins, but the internal model we’ve previously referenced pegs the EPS impact of a 10% rise in the dollar at 2.5%, far too small for a 6% rise in the dollar to drive a 7-ppt fall in margins. If the revenue estimates are accurate, it seems to us that management must be sandbagging its earnings guidance to some degree. The 10-year Treasury yield will have a harder time falling further now that the Fed is already awfully dovish. Q: Are you having any second thoughts about your duration recommendation? Our below-benchmark duration call was largely founded on our expectation that the Fed was going to surprise complacent markets by hiking more than they expected. It instead surprised dovishly, and the OIS curve responded by pricing in an additional rate cut by the end of next year. The 10-year Treasury yield melted, in accordance with our U.S. Bond Strategy service’s golden rule1 (Chart 8). Chart 8The Golden Rule The surest way to mess up a Fed call is to allow what one thinks the Fed should do to intrude on one’s assessment of what the Fed will do. We did not fall into that trap: our view that the Phillips Curve exerts considerable influence over the Fed and other central banks is founded in the observation that virtually every mainstream macroeconomic model incorporates an inverse relationship between inflation and unemployment. As noted above, we see the Fed’s hiking campaign as extended rather than ended. We believe pausing the hiking campaign will extend the expansion and allow the economy to build up more momentum. More momentum would merit higher real rates, and we also expect it would promote inflation pressures given that the output gap is already closed. We were admittedly on the wrong side as the 10-year Treasury yield fell from 3.25% to 2.4%, but still lower yields would be incompatible with our constructive view of the U.S. economy. With much of the drag on Treasury yields seeming to have come from overseas, it’s also important to note that lower major-economy yields would be incompatible with our house view that the global economy is on the cusp of rebounding (Chart 9). Chart 9Yields Rise When Green Shoots Appear Bottom Line: We missed the slide in the 10-year Treasury yield because we failed to foresee the Fed’s pivot, and because we may have focused too much on U.S., rather than global, conditions. We do not see yields falling much further, however, now that the Fed’s capacity for dovish surprises is spent, and green shoots are starting to appear in China and Europe. Q: How was the Final Four? Fantastic, and we recommend gathering some old college friends and making the trip to cheer on your alma mater should it qualify. Bring your kids if they’re old enough. If your school wins it all, you’ll share lifelong memories of the sort the Virginia alumni who attended the games will cherish. We’ll always have Minneapolis. Go ‘Hoos!   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com     Footnotes 1      Treasuries beat cash when the Fed hikes less than the money market expects, and lag cash when it hikes more than expected. Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.

Special Report

Dear Client, I hosted a Webcast on Thursday, April 4th, during which I discussed the major investment themes and views I see playing out for the rest of the year and beyond. A replay can be accessed from this link. Best regards, Peter Berezin, Chief Global Strategist Highlights The exodus of baby boomers from the labor market is likely to lower income growth, which will reduce sales growth among publicly-listed companies over the coming years. After-tax profit margins may also come under pressure, while both the risk-free interest rate and the equity risk premium could rise. While it is difficult to estimate the magnitude of these effects, our best guess is that aging will have a moderately negative, though far from catastrophic, effect on equity prices. Even if the headwinds to equities from population aging turn out to be minimal, long-term investors are still likely to earn subpar returns given that valuations are fairly stretched today. In such an environment, a nimble investment approach, which focuses on the state of the business cycle among other things, will be necessary for generating alpha. Investors should maintain a cyclically bullish stance towards global equities for the time being, but begin paring back exposure late next year in advance of a recession in 2021. Feature Will Grandpa Sink The Stock Market? About 55% of U.S. stock market wealth is held by the baby boom generation – those born between 1946 and 1964 (Chart 1). As baby boomers increasingly exit the labor force and draw down their accumulated savings, there is a growing concern that equity prices will come under pressure.  Financial pundit Robert Kiyosaki published a book more than a decade ago arguing, in his usual hyperbolic style, that retiring boomers would trigger “the biggest stock market crash in history.”1 Conveniently, he even gave a date for the crash: 2016, the year when the first baby boomers would celebrate their 70th birthdays. Kiyosaki’s prophesized crash never happened. But does he still have a point? Will aging populations torpedo stocks? A Framework For Thinking About The Value Of The Stock Market Conceptually, the value of the stock market should equal the present value of the cash flows which shareholders can expect to receive. As Appendix 1 explains, this means that today’s dividend yield should equal the difference between the rate that investors use to discount those cash flows and the expected growth rate of cash flows. The discount rate is the sum of the risk-free rate and an equity risk premium. Cash flow growth tends to track earnings growth. The latter can be broken down into sales growth and margin growth. Thus, one can express the dividend yield ( D/P )  as the sum of four variables: The formula shows that an increase in either sales growth or profit margins will reduce the dividend yield (thus implying an increase in equity prices), while an increase in either the risk-free rate (rf) or the equity risk premium (rp) will raise the dividend yield. As we discuss below, demographic trends are likely to shift all four variables in the direction of lower equity prices. As baby boomers increasingly exit the labor force and draw down their accumulated savings, there is a growing concern that equity prices will come under pressure. 1. Aging And Sales Growth At the economy-wide level, business sales closely track GDP growth (Chart 2). GDP growth, in turn, is simply the sum of employment growth and productivity growth. Chart 2Business Sales Closely Track GDP Growth As baby boomers continue to age, more and more of them will leave the labor force. This will result in slower labor force growth. While this development will weigh on GDP growth, it is important to recognize that most of the decline in labor force growth in developed economies has already occurred (Chart 3). Chart 3ADM Labor Force Growth: Most Of The Decline Has Already Taken Place (I) Chart 3BDM Labor Force Growth: Most Of The Decline Has Already Taken Place (II) The annual growth rate of the labor force in the G7 peaked at 1.7% in 1980, but has averaged only 0.3% over the past decade. The UN estimates that the number of people in G7 economies between the ages of 15 and 64 – a crude proxy for the potential size of the labor force – will contract by 0.1% per year over the next twenty years, a modest step down from positive growth of 0.1% over the past decade. Productivity growth has been quite weak in developed economies since the mid-2000s (Chart 4). Whether this trend persists remains to be seen. On the positive side, robotics, AI, and genetic engineering could all boost productivity growth. On the negative side, cognitive test scores in developed economies have peaked and are now trending lower. Consistent with this observation, Heckman and LaFontaine have shown that properly measured, the U.S. high school graduation rate has been falling since the early 1970s.2 This makes baby boomers arguably the best educated generation in history. An open question concerns the extent to which slower economy-wide GDP growth filters down to sales growth among listed companies. While it is highly likely that S&P 500 sales growth will decline in an environment of weaker growth, the impact of falling GDP growth on sales may be blunted by at least three factors. First, developed economy firms will still be able to benefit from rising sales to emerging markets, even if they are suffering from sluggish sales growth at home. Second, domestic consumption will decelerate more slowly than income growth as older workers deplete their savings. Third, lower productivity growth will coincide with less “creative destruction,” which will benefit incumbent firms. In fact, this is already happening. Chart 5 shows that net firm formation has fallen dramatically since the 1970s. Chart 4In Developed Markets, Productivity Growth Has Been Falling For Over A Decade Chart 5A Sharp Drop In New Firm Formation   2. Aging And Profit Margins Population aging can affect profit margins in two ways: First, it can shift spending across sectors. For example, if age-related spending migrates from sectors with high margins to those with low margins, aggregate profit margins will decline. Second, aging can affect margins within sectors. Looking across sectors, health care spending is likely to rise in response to population aging. According to the Congressional Budget Office, health care expenditures are set to increase from 5.2% of GDP to 9.2% of GDP by 2048 (Chart 6). There once was a time when health care margins were double the S&P 500 average (Chart 7). During the past two decades, however, health care margins have fallen, and are now slightly below the S&P average. Chart 7AS&P 500 Margins By Sector (I) Chart 7BS&P 500 Margins By Sector (II) Looking out, it is likely that health care margins will continue to contract, as cash-strapped governments look for ways to cut health care costs. Presidential hopefuls Bernie Sanders, Elizabeth Warren, and Kamala Harris have all championed “Medicare for all.” If implemented, such a policy prescription would decimate health care sector profits by reducing demand for private insurance while giving the federal government more bargaining power to negotiate lower drug prices. Most of the decline in labor force growth in developed economies has already occurred. The only silver lining, pardon the pun, for margins is that older people tend to display greater brand loyalty (Chart 8). Whether this is because of experience, habit, or nostalgia is not clear, but older consumers switch products less often, preferring to stick with “what they know.”3 Perhaps reflecting a general tendency for self-reported happiness to increase in old age, elderly consumers also tend to express greater satisfaction with their purchases. Nevertheless, on balance, we expect aging to make a slightly negative contribution to profit margins. 3. Aging And The Risk-Free Rate Proponents of the secular stagnation thesis posit that demographic trends have led to a decline in the neutral rate of interest. As Chart 9 shows, aging could depress the neutral rate if an older population causes the aggregate investment schedule to shift inwards or the aggregate savings schedule to shift outwards. Chart 9Two Ways For Real Rates To Fall According to the standard “accelerator” model, the optimal level of investment spending is determined by the growth rate of aggregate demand.4 To the extent that slower population growth discourages firms from expanding capacity, this will lead to a lower neutral rate of interest. That said, as noted above, most of the decline in labor force growth in developed economies has already occurred. This implies that investment spending may not fall much further from current levels. What about savings? At the outset, aging will increase savings as more people move into their prime saving years (ages 30-to-50). Declining fertility rates will also tend to reduce spending on children, while allowing more women to join the labor force. Aging could morph from a force that has dragged down the neutral rate of interest to one that will start slowly pushing it back up. Over time, however, aging is likely to reduce the savings rate, as more workers retire, leaving fewer workers in the labor force. Once health care spending is included, consumption actually increases in old age, especially in the last few years of life (Chart 10). Globally, the ratio of workers-to-consumers increased from the early 1970s to the middle of this decade, but has now begun to decline (Chart 11). This suggests that aging could morph from a force that has dragged down the neutral rate of interest to one that will start slowly pushing it back up. Chart 10Savings Over The Life Cycle Chart 11The Worker-To-Consumer Ratio Has Peaked Globally   Instead of running larger deficits to finance pension and health care spending, governments could raise taxes. This would reduce private consumption, thus generating additional savings for the economy. While such a step could prevent the risk-free interest rate from rising, some of the tax burden would likely end up falling on the owners of capital in the form of higher taxes on dividends, capital gains, and business profits. This would lead to lower after-tax profit margins and slower sales growth. The end result would still be the same: weaker equity prices. 4. Aging And The Equity Risk Premium When people discuss the impact that aging baby boomers will have on the stock market, they are usually – whether they realize it or not – talking about the equity risk premium. By definition, for every seller of stock there must be a buyer of stock. If baby boomers start selling shares to finance their retirement spending, someone will need to buy their shares, provided the price is low enough. The question is by how much do share prices need to fall to clear the market? In theory, households should accumulate assets over their working years and then deplete their savings in retirement. In practice, uncertainty about the timing of death, the desire to pass on wealth to future generations, and the need to maintain enough assets to finance unforeseen health care expenses all tend to induce households to run down wealth at only a modest pace during retirement. A study by John Ameriks and Stephen Zeldes using a random sample of 16,000 accounts from a major retirement fund found no evidence that households gradually decrease equity allocations as they age.5 Looking out, it is possible that baby boomers will run down their equity holdings more quickly than prior generations. For instance, the decline in family size over the past fifty years and evolving societal norms may end up causing boomers to bequeath smaller estates than in the past. The increasing popularity of annuities may also reduce the likelihood of unintended bequests. In addition, the proliferation of target-date funds may produce a more rapid shift out of equities than would occur if investors had to consciously decide to reduce exposure to the stock market. Nevertheless, we suspect that any additional selling by baby boomers will only put modest downward pressure on equity prices. This is because the wealthiest 10% of U.S. households hold 84% of all stock market wealth, while the bottom 50% hold less than 1% (Chart 12). Households in the top one percent of the wealth distribution hold close to half of all stocks. These ultra-wealthy households tend to consume a fairly small share of their assets during retirement. As a result, most of their assets end up being bequeathed to family members and/or charities when they pass away. Chart 12The Wealthiest 10% In The U.S. Own The Bulk Of Equities Chart 13Foreign Ownership Of U.S. Stocks Has Grown Foreign purchases of U.S. stocks should also blunt the impact of any selling by retiring baby boomers. Foreigners now hold 27% of U.S. stock market wealth, up from 5% in the mid-1970s (Chart 13). If foreign demand for U.S. equities increases in line with global ex-U.S. real GDP, this will add about $250 billion in demand for U.S. stocks (in constant dollars) over the next twenty years. This is five times greater than the roughly $50 billion in annual net selling that would occur if all investors followed the popular rule of thumb which instructs them to take their age and subtract it from 100 in order to determine how much of their financial wealth to allocate to equities. Investment Implications The discussion above suggests that aging is likely to have a moderately negative, though far from catastrophic, effect on equity prices by: 1) reducing sales growth among listed companies; 2) putting downward pressure on after-tax profit margins; 3) increasing the risk-free rate of interest; and 4) raising the equity risk premium. It is difficult to be precise about how large these effects will turn out to be. Three factors cloud any potential calculation. First, as the equation presented at the outset of this report illustrates, small shifts in any one variable can lead to big changes in the fair value of the stock market. To see this point, let us take the current S&P 500 dividend yield of 2.0% and add 1.5% to account for net share buybacks (gross buybacks less share issuance). This gives a “cash flow to shareholders” yield of 3.5%. Now consider a one percentage-point increase in the equity risk premium. An increase in the equity risk premium of this magnitude would require the cash flow yield to rise to 4.5%. This, in turn, would necessitate that equity prices fall by 22%. That’s a lot. The second factor that makes it difficult to be precise about the extent to which demographic changes will affect stock prices is that there are likely to be interaction effects among the variables in the equation above. For instance, rising labor shortages stemming from the withdrawal of baby boomers from the labor market could put downward pressure on profit margins. The resulting increase in labor’s share of income would likely boost aggregate demand, thereby contributing to a higher neutral rate of interest. Chart 14Japan’s Population Bust Was Largely Foreseen At this point, one of two things could happen. On the one hand, if central banks failed to raise rates, this would cause the economy to overheat, leading to higher inflation. Higher inflation could push up the equity risk premium, as was the case in the 1970s. On the other hand, if central banks did raise interest rates, this could cause debt burdens to become unsustainable. That could also push up the equity risk premium. The third factor that makes it challenging to estimate the impact of demographics on stocks is that it is difficult to know the proper baseline for computing the effects of aging on stock market valuations. To the extent that the variables in the equation are all forward-looking, they should incorporate the market’s views on how the retirement of baby boomers will affect the relevant drivers of equity returns. This implies that shifts in equity valuations must stem from forecast revisions rather than from anticipated trends. Thus, as an example, any change to the “sales growth” term should be properly viewed as expressing not how future sales growth will differ from past sales growth, but by how much future sales growth will differ from what investors are currently projecting. It is tempting to assume that the market has already priced in the impact of population aging.  After all, the fact that baby boomers are exiting the labor force is not exactly breaking news. Yet, in the past, markets have proven to be surprisingly oblivious to easy-to-predict demographic developments. For example, Japanese investors were keen to buy stocks and real estate in the late 1980s, despite the fact that published projections at the time showed that the country’s working-age population would decline at an accelerating pace over the subsequent decade (Chart 14). Academic work supports the view that investors tend to understate the importance of demographic forces. Stefano Della Vigna and Joshua Pollet have shown that a trading strategy that exploits predictable age-related changes in spending on such items as toys, bicycles, beer, and life insurance would have earned an annualized risk-adjusted return of approximately six percent.6 Chart 15Poor Long-Term Returns In Store For U.S. Stocks The fact that equity valuations today are stretched in the U.S., and no better than middling in the rest of the world, should add to investor concerns. Chart 15 shows that the ratio of household equity holdings-to-total financial assets has been an extremely reliable predictor of 10-year equity returns in the post-war era. Today, this indicator is pointing to low single-digit returns for U.S. stocks over the next decade. This suggests that even if the headwinds to equities from population aging turn out to be minimal, long-term investors will still earn subpar returns from stocks relative to recent history. In such an environment, a nimble investment approach, which focuses on the state of the business cycle among other things, will be necessary for generating alpha. As discussed in our recently published Strategy Outlook, investors should maintain a cyclically bullish stance towards stocks for the time being, but begin paring back exposure late next year in advance of a recession in 2021.7   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Robert T. Kiyosaki, and Sharon L. Lechter, “Rich Dad's Prophecy: Why the Biggest Stock Market Crash in History Is Still Coming...And How You Can Prepare Yourself and Profit from It!” Time Warner, 2003. 2      James Heckman and Paul LaFontaine, "The American High School Graduation Rate: Trends and Levels," The Review of Economics and Statistics 92:2, (May 2010): 244–262. 3      Please see Rajesh Iyer, Timothy H. Reisenwitz, and Jacqueline K. Eastman, “The Impact Of Cognitive Age On Seniors’ Lifestyles,” Marketing Management Journal, 18:2, (Fall 2008); and Komal Gyani Karani, and Katherine A. Fraccastoro, “Resistance To Brand Switching: The Elderly Consumer,“ Journal of Business & Economics Research, 8:12, (December 2010). 4      In most economic models, the capital-to-output ratio is assumed to converge towards a stable level over time. By definition, the capital stock in Year t is determined by the capital stock in Year t-1 plus whatever net investment (gross investment minus depreciation) takes place in Year t. In general, the optimal net investment-to-GDP ratio will equal the product of the capital-to-output ratio and the growth rate of GDP. For example, suppose that the capital-to-output ratio is three (meaning that the capital stock is three times as large as GDP). If output does not change from one year to the next, no additional net investment would be necessary to maintain a stable capital-to-output ratio. However, if output is growing at 2%, net investment of 3X2%=6% of GDP would be required. 5      John Ameriks and Stephen P. Zeldes, “How Do Household Portfolio Shares Vary with Age?” Working Paper, 2004. 6      Stefano Della Vigna, and Joshua M. Pollet, “Demographics and Industry Returns,” American Economic Review, 97:5 (2007). 7      Please see Global Investment Strategy, “Second Quarter 2019 Strategy Outlook: From Dead Zone To End Zone,” dated March 29, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights 10-Year Yield: In this week’s report we run through different macro factors that could be used to create a macroeconomic model of the 10-year Treasury yield, and describe the current outlook for each one. On balance, the indicators suggest that the 10-year Treasury yield is near its floor. Global Growth: Leading indicators have hooked up recently, suggesting that the Global Manufacturing PMI – a key driver of the 10-year Treasury yield – may rise in the coming months. Wages: Average hourly earnings softened in March, but survey measures suggest that wage growth remains in an uptrend. We show that rising wages have put considerable upward pressure on the 10-year yield in recent years, and should continue to do so going forward. Sentiment: The depressed Economic Surprise Index suggests that investor economic sentiment is downbeat. This means that the bar for positive data surprises (and higher bond yields) is relatively low. Feature Chart 1CRB/Gold Ratio On The Rise Treasury yields stabilized during the past week, and investors are trying to figure out whether the next big move will be higher or lower. We’re on the record as predicting that yields will eventually head higher, and have flagged the CRB Raw Industrials / Gold ratio as an important indicator to watch to time the next big move.1  Encouragingly, this indicator has risen during the past few weeks (Chart 1). Though the message from the CRB/Gold index is promising, the outlook for the 10-year Treasury yield remains uncertain. To shed some light on this important investment question, in this week’s report we run through different macroeconomic indicators that could be used to create a model of the 10-year Treasury yield. By performing this exercise out in the open, our goal is to present readers with a good way to think about the linkages between the economy and the 10-year Treasury yield. Recipe For A 10-Year Treasury Yield Model Ingredient #1: Growth Factors The first logical factor to include in any model of the 10-year Treasury yield is some measure of economic growth. We have found that the Global Manufacturing PMI is often highly correlated with the 10-year yield (Chart 2). Interestingly, the manufacturing PMI correlates more strongly with the 10-year yield than do the services or composite (manufacturing + services) PMIs. The Global PMI also correlates more strongly with the U.S. 10-year yield than does the U.S. PMI. It only takes a quick glance at the Global Manufacturing PMI to see why the 10-year Treasury yield fell this year. The Global PMI has been in a sharp downtrend for some time, driven mostly by the Euro Area and China. U.S. PMIs have also weakened in recent months, though they remain above levels seen in Europe and China. Another global growth indicator that correlates tightly with the 10-year Treasury yield is investor sentiment toward the U.S. dollar (Chart 3). Since the dollar is a countercyclical currency that appreciates when global growth slows and depreciates when it quickens, we observe that the 10-year Treasury yield tends to be lower when investors are extremely bullish on the U.S. dollar and higher when they are more bearish on the dollar. Chart 2Growth Factor Ingredient 1: Global Manufacturing PMI Chart 3Growth Factor Ingredient 2: Dollar Bullish Sentiment     Notice in Charts 2 and 3 that the Global Manufacturing PMI and dollar bullish sentiment are both close to levels seen near the 10-year yield’s mid-2016 trough. At 50.6, the PMI is only slightly above its 2016 low of 49.9. Meanwhile, dollar bullish sentiment is currently 79%. It maxed out at 82% in 2016. Interestingly, despite the fact that our economic growth indicators paint a similar growth back-drop as 2016, the 10-year yield remains well above its mid-2016 low of 1.37%. Logically, we must conclude that some other “non-growth” factor is propping yields up (more on this below). The 10-year Treasury yield tends to be lower when investors are extremely bullish on the U.S. dollar and higher when they are more bearish on the dollar.  Looking ahead, we remain optimistic that the most important global growth indicators (Global Manufacturing PMI and dollar bullish sentiment) will soon reverse course, as some leading global growth indicators have recently turned a corner. We already saw that the CRB Raw Industrials index has broken out (Chart 1). Additionally: Chart 4The Worst Is Behind Us? The Global ZEW Economic Sentiment index has risen in two consecutive months (Chart 4, top panel). Our Global LEI Diffusion Index shows that more than half of the countries in our sample now have improving leading economic indicators (Chart 4, panel 2). Our BCA Boom/Bust Indicator – an indicator based on the CRB index, Global Metals equities and U.S. unemployment claims – has also jumped (Chart 4, bottom panel). Ingredient #2: Output Gap As noted above, the 10-year Treasury yield looks too high relative to our preferred economic growth indicators. This could be because yields haven’t yet caught up to the deteriorating global economy, but more likely it is because our bond model is still missing some key ingredients. The next most obvious factor to incorporate into our model is some measure of the output gap. If an economy is operating at very close to its peak capacity, with a small output gap, then it doesn’t take much additional growth to spark inflation. Conversely, even rapid economic growth will not be inflationary if the output gap is large. As long as the central bank is expected to lean against rising inflation with higher interest rates, then some measure of the output gap should be included in our bond model. Unfortunately, appropriate output gap measures are difficult to find. We could rely on the CBO or IMF’s output gap estimates, but those are often subject to large ex-post revisions – not ideal if we want to create a bond model that is useful in real time. Since the Fed tends to lift rates when the output gap closes, another option would be to include the fed funds rate as an independent variable in our model. However, this is also not ideal since we would expect the macroeconomic data and the 10-year yield to lead changes in the policy rate. Some measure of inflation might be the best factor to include. However, we find that the correlation between different price inflation measures and the 10-year Treasury yield is incredibly unstable over time. This is likely because the Fed targets price inflation explicitly, making its correlation with bond yields less empirically apparent. Wage growth is the best “output gap” measure to include in a 10-year Treasury yield model.  In fact, our analysis reveals that wage growth is the best “output gap” measure to include in a 10-year Treasury yield model. Specifically, average hourly earnings from the monthly employment report. Not only does the fed funds rate respond – with a lag – to changes in average hourly earnings, but average hourly earnings also line up reasonably well with the 10-year yield over time (Chart 5). Looking at Chart 5, we can now clearly see why the 10-year yield is above its mid-2016 low, despite the poor readings from our growth indicators. Wages have risen sharply since mid-2016, indicating that the output gap has closed, and the Fed has hiked rates 8 times as a result. The obvious conclusion is that in the present situation, with a much smaller output gap than in 2016, it would require a Global Manufacturing PMI well below 50 to produce a 10-year yield near 2% or below. Going forward, we see the uptrend in wage growth continuing for some time. The proportion of workers quitting their jobs each month, a signal of worker bargaining power, remains very high relative to history. Meanwhile, many more households continue to describe jobs as “plentiful” as opposed to “hard to get” (Chart 6). Chart 5Output Gap Ingredient: Average Hourly Earnings Chart 6More Room For Wages To Grow Ingredient #3: Policy Uncertainty The third ingredient we’ll add to our 10-year Treasury yield model is a measure of policy uncertainty. Specifically, the index of Global Economic Policy Uncertainty created by Baker, Bloom and Davis.2  Investors often flock to the safety of U.S. Treasuries in times of economic distress. But Treasuries can also benefit from flight-to-quality flows during periods of stable economic growth but heightened political turmoil. In other words, elevated political uncertainty can make investors fear a downturn in the future, and drive a flight into the safety of U.S. Treasuries. The Global Economic Policy Uncertainty index also shows a relatively strong correlation with the 10-year Treasury yield over time (Chart 7). Chart 7Policy Uncertainty Ingredient: Global Economic Policy Uncertainty Index Looking more closely at Chart 7, we see that global policy uncertainty is currently as high as it was in mid-2016, when the 10-year Treasury yield hit its cycle low. This lines up pretty well with intuition, since investors are understandably quite nervous about the state of Brexit negotiations and U.S./China trade relations. In that context, it is reasonable to expect that some geopolitical risk premium is currently priced into the 10-year Treasury yield, though a smaller output gap than in 2016 is preventing the 10-year yield from reaching mid-2016 levels. Going forward, though political uncertainty will probably stay elevated compared to history. It seems increasingly likely that a “hard Brexit” will be avoided and that President Trump will seek some sort of agreement with China in advance of the 2020 U.S. election.3 The political risk premium in 10-year notes could unwind somewhat in the coming months. Ingredient #4: Sentiment The fourth and final ingredient we’ll add to our 10-year Treasury yield model is a component related to investor sentiment. Our favorite being the U.S. Economic Surprise Index. Chart 8Sentiment Ingredient: Economic Surprise Index Investors don’t often think of the Surprise index as a sentiment indicator, but in fact that’s exactly what it is. It measures whether the economic data exceeded or fell short of expectations during the past 30 days, a measurement that is heavily influenced by whether investor expectations are optimistic or pessimistic. When economic expectations are extremely downbeat it doesn’t take much good news to generate a positive surprise, and vice-versa. Also, investor expectations are influenced in one direction or the other by whether the recent economic data are positive or negative. This behavioral dynamic causes the Economic Surprise Index to be a mean-reverting series, one that we can even describe with a simple auto-regressive model, as shown in Chart 8. More importantly, we have found that the Economic Surprise Index is tightly correlated with the change in the 10-year Treasury yield. A given month that ends with the Surprise index above zero is usually a month when the 10-year Treasury yield increased, and vice-versa (Chart 9). This correlation also holds relatively well over 3-month and 6-month horizons (Charts 10 & 11), but breaks down beyond that.4   The U.S. data surprise index is deeply negative at present, and has been for several weeks. But the longer the data continue to disappoint, the more downbeat investor expectations become and the more likely it is that the surprise index will rise in the future. Right now, our simple auto-regressive model projects that the surprise index will be slightly higher in one month’s time, though still deeply negative. Nevertheless, the Surprise index suggests we are approaching a turning point in investor sentiment. Mix Well, Cover, Stir Occasionally We’ve now presented what, in our view, is a fairly complete list of factors that should be included in a macroeconomic model of the 10-year Treasury yield. Importantly, each factor complements the other ones in the sense that they each capture a different element of the economic landscape. At this stage, it would be nice to weight all of the factors together and arrive at a fair value estimate for the 10-year yield. Unfortunately, we won’t be performing that exercise in this report (we may do so in the future). The key challenge in combining all of the indicators together is that the sensitivity of the 10-year yield to each of the above factors changes over time. For example, there are periods when policy uncertainty appears to be a very significant driver of the 10-year yield, and other times when it appears to not matter much at all. The macro indicators listed in this report generally signal that the 10-year yield is near its trough. While it is often useful to boil all of the important drivers down into a point estimate of the 10-year yield, such an exercise can also create problems if it causes us to zero-in on the model’s output and avoid thinking critically about what the different macro inputs are telling us. As of today, we think the macro indicators listed above generally signal that the 10-year yield is near its trough. Leading global growth indicators have hooked up, suggesting that the Global Manufacturing PMI will improve during the next few months and that bullish dollar sentiment could soften. Survey indicators suggest that the labor market remains tight, and that wage growth will stay in an uptrend. Policy uncertainty will probably continue to apply some downward pressure to yields, but a long Brexit extension and/or trade agreement between the U.S. and China could cause that impact to wane in the next few months. Economic sentiment is likely quite depressed, meaning that the bar for positive surprises is low. All in all, our investment strategy is unchanged. We recommend that investors maintain below-benchmark duration in U.S. bond portfolios, while focusing short positions on the 5-year and 7-year maturities.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 The rationale for tracking the CRB/Gold ratio can be found in U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 2 www.policyuncertainty.com 3 Please see Global Investment Strategy Quarterly Outlook, “From Dead Zone To End Zone”, dated March 29, 2019, available at gis.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “How Much Higher For Yields?”, dated October 31, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Duration: A growing list of leading global growth indicators are either climbing or are in the process of bottoming. This is putting a floor under global bond yields, as signaled by our new GFIS Duration Indicator. Maintain a below-benchmark overall duration stance in global bond portfolios. New Zealand: The RBNZ has signaled that the next move in policy rates is down in New Zealand, a move that would be justified by slowing domestic growth and below-target inflation. Stay long New Zealand 5-year government bonds versus equivalent maturity U.S. Treasuries and German debt, but set fairly tight stops to protect profits given how far spreads have already compressed. Feature A New Duration Indicator … But No Change In Our Duration Stance The downward pressure on global government bond yields looks to be losing steam. The “inversion panic” in the U.S. Treasury market has subsided with the 10-year Treasury yield climbing back above 2.50% last week. Yields have bounced well off the lows in the major markets, as well, including the 10-year German Bund which is no longer in negative yield territory. Some tentative signs of stabilization in global growth indicators has helped stem the flow of bond-bullish news, coming alongside a pickup in commodity prices. The new rising trend in our GFIS Duration Indicator suggests that investors should maintain a strategic below-benchmark overall duration stance in global bond portfolios. We have combined some of those growth indicators, which have been reliably correlated with global bond yields over the past several years, into our new Global Fixed Income Strategy (GFIS) Duration Indicator (Chart of the Week). This indicator is a combination of the standardized levels of our global leading economic indicator (LEI), our global LEI diffusion index (the relative share of countries in our global LEI where the LEI is rising versus where it is falling) and the global ZEW economic expectations index (a combination of the individual country indices produced by the German ZEW Institute). Chart of the WeekOur New GFIS Global Duration Indicator Has Bottomed Out Chart 2Early Signs Of A Global Growth Recovery   The GFIS Duration Indicator has provided a reliable directional signal for global bond yields since 2012, with a lead of six months. The indicator bottomed back in October 2018 and, with that six month lead, signals that global bond yields should be bottoming now (April 2019). Two of the three components of the GFIS Duration Indicator – the global LEI diffusion index and the global ZEW expectations index – have both clearly bottomed and are the main reason why the Indicator has started to move higher (Chart 2). The global LEI has stopped falling, as well, and is no longer putting downward pressure on the Indicator. Combined with the readings on price momentum for global government bonds (very overbought) and duration positioning among bond investors (well above-benchmark), it is no surprise that bond yields have finally had a chance to stabilize. Looking at the individual country components of these indicators, it is clear that the pickup in sentiment seen in the U.S., euro area, Japan and the U.K. has not been matched by a pickup in their individual LEIs (Chart 3). Interestingly, there are signs of life in some of the individual emerging market (EM) LEIs in places like Mexico.1 The biggest country to watch for improvement, of course, is China and, even here, the sharp deceleration of the OECD LEI appears to be losing steam. The new rising trend in our GFIS Duration Indicator suggests that investors should maintain a strategic below-benchmark overall duration stance in global bond portfolios. Yields may not come roaring back quickly until there is more decisive evidence of improving global growth. On a risk/reward basis, though, betting on higher bond yields from current levels appears prudent. Our new GFIS Duration Indicator may also prove to be useful in guiding fixed income allocation between government bonds and corporate debt in the future. In Chart 4, we show the performance of global government bond yields, corporate bond spreads and corporate excess returns (over duration-matched government debt) since the start of 2018. The shaded region represents the time frame when we moved to a more cautious stance on global corporates versus governments (from June 26, 2018 to Jan 15, 2019). Chart 3Could EM Lead DM Out Of The Slump? Chart 4Our Duration Indicator Can Help With Asset Allocation Our decision to downgrade corporates was based on our concern that slowing global growth, tighter U.S. monetary policy and growing U.S.-China trade tensions would result in a risk-off pullback in global risk assets like corporate bonds and equities. Yet we could have made a similar decision when looking at only the GFIS Duration Indicator. The most recent peak in the Indicator occurred in October 2017, occurring about one full year before the blowout in credit spreads. In a future report, we will investigate the potential links and optimal lead/lag relationships between the GFIS Duration Indicator and fixed income allocation. Bottom Line: A growing list of leading global growth indicators are either climbing or are in the process of bottoming. This is putting a floor under global bond yields, as signaled by our new GFIS Duration Indicator. New Zealand Spread Trade Update – Too Soon To Take Profits Chart 5Impressive Outperformance From NZ Bonds One of our more successful calls over the past two years has been to go long New Zealand (NZ) government bonds versus U.S. Treasuries and German sovereign debt. Since we initiated that recommendation back on May 30, 2017, the 5-year NZ-US spread has tightened from +74bps to -74bps, while the 5-year NZ-Germany yield differential has narrowed from +289bps to +213bps (Chart 5). Relative to the Bloomberg Barclays Global Treasury index (on a duration-matched basis, hedged into U.S. dollars), NZ government bonds have outperformed by +413bps, compared to +289bps for euro area debt and -269bps for U.S. debt. Our original thesis was that market expectations for the Reserve Bank of New Zealand (RBNZ) were too hawkish relative to decelerating NZ economic growth and inflation persistently coming in below the central bank’s 2% target. Any rate hikes discounted in the NZ yield curve were unlikely to be delivered against that backdrop, keeping NZ bond yields contained. We preferred to position this benign view on NZ rates as a bond spread trade versus the U.S., where the Fed was in a tightening cycle, and versus Germany where a cyclical growth upswing was shifting the ECB in a less-dovish direction. The returns on our NZ recommendation have far exceeded our expectations, with the benchmark 10-year NZ bond yield having fallen -82bps since we initiated the position. The more recent part of that decline has come from the markets moving to price in RBNZ rate cuts over the next year. The bigger driver of the yield move, however, has been due to markets discounting a lower medium-term neutral level of the RBNZ’s policy rate, the Official Cash Rate (OCR). Our proxy for the market expectation of the real terminal rate (the inflation-adjusted level of interest rates derived from forward pricing in the NZ overnight index swap (OIS) curve and medium-term inflation expectations taken from inflation-linked bonds) has fallen from 2.2% in May 2017 to 1.4% today (Chart 6). This is in sharp contrast to the pricing of the real terminal rate in the U.S. and core Europe, which has remained in a narrow range near 0% over the same period. As we discussed in a recent Weekly Report, there has been a trend in recent years towards convergence of real terminal rate expectations across most developed economies – a move driven by a narrowing of differentials in medium-term labor productivity and inflation.2 In the case of NZ, however, the sharp downward adjustment of interest rate expectations also had a cyclical component. Investors are seeing a steady deceleration of NZ growth, even with the RBNZ keeping policy rates at historically-low levels. The result: a reduction of expectations for the terminal (or “neutral”) interest rate. One of our more successful calls over the past two years has been to go long New Zealand (NZ) government bonds versus U.S. Treasuries and German sovereign debt. The economy has faced a broad-based deceleration since the middle of 2016 and is now growing at a below-trend pace of 0.9%. A slower global economy has hit NZ exporters hard, with the annual pace of export growth having slowed from 20% to 4% since last December. The NZ manufacturing PMI has also fallen over the same period, but at 54 remains above the boom/bust 50 level (Chart 7). The RBNZ’s own business surveys show huge declines in confidence, capacity utilization and the outlook for export demand. Chart 6A Big Convergence Of Interest Rate Expectations Chart 7Slowing Global Growth Has Hit NZ Hard   Monetary conditions had to become easier to help mitigate the external shock to NZ growth. This did happen through a weaker New Zealand dollar (NZD) – which fell -8% on a trade-weighted basis from the most recent peak in March 2014 – but not through interest rates, as the RBNZ has kept the OCR steady at 1.75% since November 2016. Looking across the NZ economy, a case can be made for introducing additional monetary stimulus. Could the next move to ease monetary conditions be actual rate cuts from the RBNZ? There are now -40bps of cuts over the next twelve months discounted in the NZ OIS curve. RBNZ Governor Adrian Orr stated last month that, given weaker global growth with reduced momentum in domestic spending and core inflation remaining below target, the next move for the OCR is likely down. Looking across the NZ economy, a case can be made for introducing additional monetary stimulus: Chart 8NZ Growth Has Slowed A Lot From The 2015/16 Boom   Growth: Real consumer spending has decelerated sharply from the 2015/16 boom years, with the annual growth falling from a peak of 6.1% in 2016 to 3.5% in Q4/2018 (Chart 8). A weaker housing market, fueled by slower inflows of new immigrants, has been an important factor underlying the softer pace of consumer spending. Capital spending by NZ companies has also slowed substantially from the robust 2015/16 pace, a consequence of weaker global demand (both from China and Australia, the most important export markets for NZ) and stagnant prices for important NZ commodities like dairy products. Importantly, the broad-based deceleration of NZ economic growth appears to have stabilized, although there is little sign of an imminent reacceleration in domestic demand. Labor Markets & Inflation: NZ’s labor market has been very strong. The unemployment rate of 4.3% sits well below both the RBNZ and OECD estimates of full employment. The labor force participation rate has climbed a full three percentage points since 2015 and is now stable around 71% (Chart 9). Job vacancies were up 7.2% on a year-over-year basis in Q4 2018, with full-time employment growth holding stable at 3.1% even as part-time employment growth has been contracting. This all suggests that the pool of available workers has become tight enough to allow part-time workers to find full-time work and wages to accelerate. Yet despite +3% wage growth persisting over the past year, both headline and core CPI inflation has remained stubbornly below 2% (the midpoint of the RBNZ 1-3% target band) since the end of 2014. Chart 9Tight NZ Labor Markets, But Where's The Inflation?   Against this backdrop of slowing growth but underwhelming inflation, the RBNZ would be justified in delivering a rate cut or two to provide a boost to the economy. The RBNZ’s latest set of economic forecasts are not overly pessimistic with real GDP expected to grow at a 3% pace in 2019 and 2020. Governor Orr has noted, however, that the weakness in consumer spending is the biggest downside threat to the central bank’s growth forecasts. More importantly, despite forecasting that the NZ labor market will remain tight (i.e. beyond full employment), and the output gap will remain above zero (i.e. no spare capacity), the central bank does not expect inflation to return to the 2% target until 2021. Pricing in inflation-linked NZ government bonds is even more pessimistic, with longer-term inflation breakevens now sitting below 1%. Adding to the dovish bias of the RBNZ is the revised mandate for the central bank from the NZ government. The RBNZ now has a dual mandate similar to the U.S. Federal Reserve, targeting both stable inflation and maximum sustainable employment. The central bank has also moved away from having the RBNZ Governor solely make decisions, with a new seven-person monetary policy committee now voting on policy changes.3 Governor Orr stated last week that the RBNZ’s new dovish bias introduced in March will be “the starting point” for deliberations by the enlarged monetary policy committee. Such a candid statement suggests that the committee’s first formal policy meeting on May 8 will be dedicated to discussing the need for a rate cut. Yet even if the RBNZ does ease in May, the markets are already priced for such an outcome. The NZ OIS curve discounts -32bps of cuts within the next six months, and -18bps of cuts in the next three months. So what does this all mean for our NZ spread trades? In Charts 10 & 11, we present a “fair value” regression model for the 5-year NZ-US and 5-year NZ-Germany bond spreads. The independent variables in the model are based on relative monetary policy, relative growth and relative inflation between NZ and the U.S. and Germany. The logic is that the bond spread should be a function of the differentials between policy interest rates, unemployment rates and inflation rates.   Chart 10Our NZ-US 5-Year Spread Model Chart 11Our NZ-Germany 5-Year Spread Model The model is indicating that the NZ-US spread is far too tight, although this is not unusual when looking at the very wide spreads between U.S. Treasury yields and bonds from other countries which are also historical extremes (i.e. Germany, Australia and the U.K.). As discussed earlier, the market pricing of NZ neutral real interest rates has converged substantially towards the lower levels seen in other developed countries. This suggests that the unusually narrow spreads reflect a structurally lower interest rate environment in NZ, which has historically been a country with some of the highest nominal rates and bond yields in the developed world. Adding it all up, we think that the conditions for a widening of NZ-US and NZ-German spreads is not yet in place. Thus, we are sticking with our recommended spread trades. Our model for the NZ-Germany spread also suggests that the spread is getting too tight, although it is still within the normal ranges (+/- 1 standard deviation) of fair value. So on the basis of valuation, the period of NZ bond outperformance looks stretched. In terms of what is discounted in NZ money markets, it is unlikely that the RBNZ will deliver on the -39bps of rate cuts currently discounted in the OIS curve over the next year without a sharper downleg in both growth and inflation (that also pushes up unemployment). Yet at the same time, the backdrop for global bond yields is shifting due to bottoming global growth that is likely to put more upward pressure on U.S. and German yields than NZ yields, which have already fallen substantially. Adding it all up, we think that the conditions for a widening of NZ-US and NZ-German spreads is not yet in place. Thus, we are sticking with our recommended spread trades. Given the overvaluation signals from our new fair value models, however, we do recommend setting a stop on these spread positions to protect profits. For the 5-year NZ-US spread, which is currently at -74bps, we are setting a fairly tight stop at -60bps given how overvalued that spread looks in our model. For 5-year NZ-Germany, which is currently at +207bps, we are setting a slightly wider stop at +230bps. Bottom Line: The RBNZ has signaled that the next move in policy rates is down in New Zealand, a move that would be justified by slowing domestic growth and below-target inflation. Stay long New Zealand 5-year government bonds versus equivalent maturity U.S. Treasuries and German debt, but set fairly tight stops to protect profits given how far spreads have already compressed.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Footnotes 1 Note that we are using the OECD set of leading economic indicators in this analysis. 2 Please see BCA Global Fixed Income Strategy Weekly Report, “Pervasive Uncertainty, Persuasive Central Banks”, dated March 12th 2019, available at gfis.bcaresearch.com. 3 A lengthy but detailed Monetary Policy Handbook, highlighting the philosophy and new policy framework for the Reserve Bank of New Zealand, can be found here. https://www.rbnz.govt.nz/monetary-policy/about-monetary-policy/monetary-policy-handbook Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns