Gov Sovereigns/Treasurys

Highlights Duration: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Fed: Low inflation expectations mean that the Fed is unconstrained when it comes to easing policy. Rate cuts will continue until either the funds rate reaches zero, or financial markets signal that enough stimulus has been delivered. Spread Product: Investors with 12-month investment horizons should neutralize allocations to spread product versus Treasuries, including high-yield where the recent oil supply shock will weigh heavily on returns. Investors should also downgrade exposure to MBS with the goal of re-deploying into corporate credit once the current risk-off episode runs its course. Feature Risk off sentiment prevailed in financial markets again last week, as COVID-19 continues to spread throughout the world. Most recently, the city of Milan has been placed under quarantine and New York state has declared a state of emergency. It is difficult to have much certainty about the virus’ ultimate economic impact, but the prospect of US recession looms larger and larger. In bond markets, the 10-year Treasury yield has fallen to 0.54% and the yield curve is pricing-in 91 bps of Fed rate cuts over the next 12 months (Chart 1). If those expectations are met, it would bring the funds rate down to 0.18%, only slightly above the zero-lower-bound. Chart 1Market Priced For A Return To The Zero-Lower-Bound On the bright side, there is ample evidence that global economic growth was trending up before the virus struck in late January, and we remain confident that a large amount of pent-up demand will be unleashed once its impact fades. However, we have no clarity on how much longer COVID-19 might weigh on growth. For this reason, we recommend a much more defensive US bond portfolio allocation, even for investors with 12-month horizons. Specifically, investors should keep portfolio duration close to benchmark and reduce spread product allocations to neutral. The market is sending the message that more rate cuts are needed. We will be quick to re-initiate a below-benchmark duration recommendation when we think that bond yields are close to bottoming. In the below section titled “How To Call The Bottom In Yields”, we discuss the factors that will help us make that decision. A State Of Monetary Policy Emergency The Fed took quick action last week, delivering an inter-meeting 50 basis point rate cut as the stock market tumbled on Tuesday morning. Alas, the market is sending the message that those 50 bps won’t be enough. Fed funds futures are pricing-in another 82 bps of easing by the end of next week’s FOMC meeting, followed by further cuts in April (Table 1). Table 1Expectations Priced Into The Fed Funds Futures Curve Of course, easier monetary policy is not the solution to what ails the global economy. At his press conference last week, Fed Chair Powell justified the emergency cut by saying that it will help “avoid a tightening of financial conditions which can weigh on activity, and it will help boost household and business confidence.” This is a fair assessment of what monetary policy can hope to accomplish in the current environment. At most, monetary policy can limit the damage in financial markets, which is a worthwhile goal given the strong historical correlation between financial conditions and economic growth (Chart 2). Chart 2Fed Must Do Its Best To Support Financial Conditions What’s more, with inflation expectations at very low levels – as we go to press the 10-year TIPS breakeven inflation rate is a mere 1.03% – there is no reason for the Fed to resist easing policy, even if the expected benefits from easing are small. Chart 3Markets Demand More Easing From our perch, the only possible reason for the Fed to refrain from cutting rates quickly all the way back to zero would be to preserve some monetary policy ammunition for when it is needed most. The Fed probably doesn’t see things this way. In conventional economic models it is the level of interest rates that influences economic activity. Therefore, the way to get the most bang for your stimulus buck is to cut rates to zero as quickly as possible. However, if monetary policy is primarily influencing the economy via its impact on financial conditions and investor sentiment, as Chair Powell claimed, then it would be advisable to only deliver rate cuts when financial conditions are tightening rapidly. That is, don’t cut rates if the stock market is rebounding, save your ammo for when equities are in free fall and panic is widespread. We can’t know for certain what the Fed will do between now and the next FOMC meeting. But we can say that, with inflation pressures low, there are no constraints against cutting rates back to the zero bound. The safest takeaway for bond investors is to assume that rate cuts will continue until either (i) the fed funds rate hits zero or (ii) we see signs that the markets and economy are no longer calling for further stimulus. Those signs would be (Chart 3): Yield curve steepening, particularly at the short end. Stocks outperforming bonds. A rising gold price. A falling US dollar. Bottom Line: More rate cuts are coming, and they won’t stop until either the fed funds rate hits zero or financial markets signal that sufficient stimulus has been delivered. We can’t be certain whether that will occur with more or less than the 91 bps of rate cuts that are currently priced for the next 12 months. As such, we recommend keeping portfolio duration close to benchmark. How To Call The Bottom In Yields The US economy is on the cusp of entering a downturn of uncertain duration that will likely be followed by a rapid recovery. Given that outlook, the next big call to make is: When will bond yields put in a bottom? We identify four catalysts that we will monitor to make that call. 1. Virus Panic Abates This is the most important catalyst that could lead us to re-initiate a below-benchmark duration recommendation. The pattern of past viral outbreaks is that bond yields tend to fall until the number of daily new cases reaches zero. This is precisely what happened during the 2003 SARS epidemic (Chart 4A). As for COVID-19, the number of daily new cases looked like it was approaching zero a few weeks ago, but then reversed course as the virus moved on from China to the rest of the world (Chart 4B). One ray of hope is that the number of new cases in China is approaching zero. This suggests that it will also be possible for other countries to contain the virus, but right now it is unclear how long that will take. Chart 4AYields Will Bottom When New Cases Reach Zero Chart 4BNew COVID-19 Cases Still ##br##Rising   In sum, we will keep tracking the global daily number of new cases and will shift to a below-benchmark duration recommendation as it approaches zero. 2. Global Economic Data Improve (Especially China) Chart 5Waiting For A Global Growth Rebound China is where the COVID-19 outbreak started and it is also where we are now seeing the impact in the economic data. The Global Manufacturing PMI dropped from 50.4 to 47.2 in February, due in large part to the plunge in China’s index from 51.1 to 40.3 (Chart 5). In order to call the bottom in US bond yields we will need to see evidence that China can come out the other side of the economic downturn. This means seeing an improvement in the Chinese and Global Manufacturing PMIs. We would also like to see improvement in other global growth indicators such as the CRB Raw Industrials index (Chart 5, panel 2) and the relative performance of cyclical versus defensive equity sectors (Chart 5, bottom panel). Aggressive Chinese stimulus (both monetary and fiscal) might help speed this process along. China’s credit impulse is on the rise (Chart 5, panel 2), and our China Investment Strategy service observed that recently announced policy initiatives related to infrastructure, housing and the automobile sector resemble those that led to a V-shaped Chinese economic recovery in 2016.1  We will be inclined to shift back to below-benchmark portfolio duration when the Global Manufacturing PMI, CRB Raw Industrials index and the relative performance of cyclical versus defensive equities move higher. 3. The US Economic Data Worsen Chart 6Waiting For Weaker US Data While the Global and Chinese economic data are currently in the doldrums, we still haven’t seen COVID’s impact on the US economy. The US ISM Manufacturing PMI is in expansionary territory and the Services PMI is at a healthy 57.3 (Chart 6). Meanwhile, US employment growth has averaged +200k during the past 12 months (Chart 6, panel 2) and the US Economic Surprise Index is above 60 (Chart 6, bottom panel)! Until the US economic data take a hit, another downleg in US bond yields is likely. Looking ahead, if the Global and Chinese economic data are improving as the US data are weakening, financial markets will extrapolate from the Chinese experience and start to price-in an eventual US recovery. Therefore, bond yields will probably start to move higher while the US economic data are still weak. For this reason, one catalyst for us to re-initiate below-benchmark portfolio duration will be when the US economic data weaken. 4. Technical Signals Table 2The 3-Month Golden Rule We don’t recommend relying on technical trading rules when forming a 12-month investment view, but technical signals can help add discipline to investment strategies, especially when calling tops and bottoms. One framework with a decent track record is our Golden Rule of Bond Investing applied to a shorter 3-month investment horizon.2 While this 3-month rule doesn’t work as well as when it is applied to a 12-month horizon, we still find that if you correctly predict whether the Fed will deliver a hawkish or dovish surprise relative to market expectations during the next three months, you will make the right duration call 63% of the time (Table 2). The 3-month Golden Rule worked better for dovish surprises than for hawkish surprises in our sample but delivered solid results in both cases. The median 3-month excess Treasury index return versus cash was -1.09% (annualized) when there was a hawkish Fed surprise, compared to +2.56% (annualized) when there was a dovish Fed surprise. For context, the median annualized 3-month excess Treasury index return versus cash during our sample period was +1.79%. Until the US economic data take a hit, another downleg in US bond yields is likely. The overnight index swap curve is currently priced for 94 bps of rate cuts during the next three months, which would essentially take the funds rate back to the zero bound. As of now, we cannot rule out this possibility and are therefore not inclined to look for higher yields during the next 3 months. Momentum, Positioning & Sentiment Other technical signals can also help call tops and bottoms in bond yields. One such signal comes from our Composite Technical Indicator, an indicator that is based on yield changes, investor sentiment surveys and positioning in bond futures markets. Right now, the indicator is sending a strong “overbought” signal with a reading below -1 (Chart 7). Chart 7Technical Treasury Signals In isolation, an overbought signal from our Composite Technical Indicator is not a strong reason to call for higher yields. We found that, historically, a reading below -1 from our indicator precedes a 3-month move higher in the 10-year Treasury yield only 53% of the time (Table 3). Table 3Technical Treasury Indicator Performance (1995 – Present) One reason for the Composite Technical Indicator’s mediocre performance is that, even at low levels, the market can always become more overbought. But we can partially control for this by combining the overbought signal from our indicator with simple momentum measures that might signal a trend reversal. For example, a reading below -1 from our Composite Technical Indicator combined with a 1-week increase in the 10-year yield precedes a higher 10-year yield during the next three months 58% of the time. If we wait for a 2-week increase in the 10-year yield the rule’s success rate rises to 60%, and it rises to 71% if we wait for the 10-year yield to break above its 4-week moving average. At present, our Composite Technical Indicator shows that Treasuries are extremely overbought, but momentum measures are sending no signals about an imminent trend change (Chart 7, bottom 3 panels). Bottom Line: It is too soon to call the bottom in bond yields. To help make that call we will be looking for when: daily new COVID-19 infections reach zero, global growth indicators improve, US economic indicators worsen, technical indicators signal a reversal. Some Quick Notes On TIPS, MBS And Spread Product Allocations Along with raising recommended portfolio duration to benchmark on a 12-month horizon, we also recommend neutralizing exposure to spread product in US bond portfolios. This includes reducing exposure to high-yield corporate bonds. High-yield remains attractively valued but will continue to sell off as long as risk-off market sentiment prevails. The looming oil price war will also weigh heavily on the sector, which is highly exposed to the US shale energy space. Once again using the SARS epidemic as a comparable, we see that – like Treasury yields – junk excess returns bottomed when the number of daily new cases approached zero (Chart 8). We could still be relatively far from this point, so taking risk off the table makes sense.  New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. We also recommend moving MBS allocations to underweight. New all-time lows in Treasury yields will drag mortgage rates lower and lead to a spike in refinancing activity. This spike is not yet fully reflected in MBS spreads, which remain relatively tight (Chart 9) Chart 8Too Soon To Call For Peak Junk Spreads Chart 9Downgrade MBS . Going forward, even after the economic fallout from COVID-19 has passed and it is time to increase exposure to spread product, we will likely continue to recommend an underweight allocation to MBS because better opportunities will be available in investment grade and high-yield corporate bonds where spreads will be much more attractive. On TIPS, last weekend’s oil supply shock – combined with the demand shock from COVID-19 – will conspire to keep long-maturity TIPS breakeven inflation rates well below their “fundamental fair value” for some time yet. But for investors with longer time horizons we see exceptional value in TIPS relative to nominal Treasuries. Even before yesterday’s big drop in oil, the 10-year TIPS breakeven inflation rate was 52 bps cheap relative to the fair value reading from our Adaptive Expectations Model (Chart 10).3 Chart 10TIPS Offer A Ton Of Long-Run Value Investors with 12-month investment horizons should continue to favor TIPS over nominal Treasuries, but those with shorter horizons may be advised to stand aside and wait for the daily number of new COVID-19 cases to reach zero before re-initiating the position.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?”, dated February 26, 2020, available at cis.bcaresearch.com 2  For more details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com 3 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights An analysis on Colombia is available below. If EM share prices hold at current levels, a major rally will likely unfold. If they are unable to hold, a substantial breakdown will likely ensue. The direction of EM US dollar and local currency bond yields will be the key to whether EM share prices break down or not. We expect continuous EM currency depreciation that will likely trigger foreign capital outflows from both EM credit markets and domestic bonds. This leads us to reiterate our short position in EM stocks. We are booking profits on the long implied EM equity volatility and the short Colombian peso/long Russian ruble positions. Feature The Federal Reserve’s intra-meeting rate cut this week might temporarily boost EM risk assets and currencies. However, it is also possible that investors might begin questioning the ability of policymakers in general and the Fed in particular to continuously boost risk assets. In recent years, investors have been operating under the implicit assumption that policymakers in the US, China and Europe have complete control over financial markets and global growth, and will not allow things to get out of hand. Investors have been ignoring contracting global ex-US profits as well as exceedingly high US equity multiples and extremely low corporate spreads worldwide. In the past 12 months, investors have been ignoring contracting global ex-US profits (Chart I-1) as well as exceedingly high US equity multiples. This has been occurring because of the infamous ‘policymakers put’ on risk assets. As doubts about policymakers’ ability to defend global growth and financial markets from COVID-19 heighten, investors will likely throw in the towel and trim risk exposure. A sudden stop in capital flows into EM is a distinct possibility. The Last Line Of Defense EM share prices are at a critical juncture (Chart I-2). If they hold at current levels, a major rally will likely unfold. If they are unable to hold at current levels, a substantial breakdown will likely ensue. Chart I-1Profitless Rally In 2019 Makes Stocks Vulnerable Chart I-2EM Share Prices Are At A Critical Juncture   What should investors be looking at to determine whether EM share prices will find a bottom close to current levels, or whether another major down-leg is in the cards? In our opinion, the direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Chart I-3 illustrates that EM equity prices move in tandem with EM corporate US dollar bond yields as well as EM local currency bond yields (bond yields are shown inverted on both panels). Falling EM fixed income yields have helped EM share prices tremendously in the past year. Chart I-3EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM corporate US dollar bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when EM credit spreads are widening more than Treasury yields are falling; or (3) when both US government bond yields and EM credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for US government bonds, presently EM corporate US dollar bond yields can only rise if their credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently rests with EM corporate spreads. EM corporate and sovereign credit spreads are breaking above a major technical resistance (Chart I-4). The direction of these credit spreads is contingent on EM exchange rates and commodities prices as demonstrated in Chart I-5. Credit spreads are shown inverted in both panels of this chart. Chart I-4A Breakout In EM Sovereign And Corporate Credit Spreads? Chart I-5Falling EM Currencies And Commodities Herald Wider EM Credit Spreads   EM exchange rates are also crucial for foreign investors’ in EM domestic bonds. The top panel of Chart I-6 demonstrates that even though the total return on the JP Morgan EM GBI domestic bond index has been surging in local currency terms, the same measure in US dollar terms is still below its 2012 level. The gap is due to EM exchange rates. EM local currency bond yields are at all-time lows (Chart I-6, bottom panel), reflecting very subdued nominal income growth and low inflation in many developing economies (Chart I-7). Chart I-6EM Currencies Are Key To EM Domestic Bonds Total Returns Chart I-7Inflation Is Undershooting In EM Ex-China   Hence, low EM domestic bond yields are justified by their fundamentals. Yet foreign investors are very large players in EM local bonds, and their willingness to hold these instruments is contingent on EM exchange rates’ outlook. The sensitivity of international capital flows into EM US dollar and local currency bonds to EM exchange rates has diminished in recent years because of global investors’ unrelenting search for yield. As QE policies by DM central banks have removed some $9 trillion in high-quality securities from circulation, the volume of fixed-income securities available in the markets has shrunk. This has led to unrelenting capital inflows into EM fixed-income markets, despite lingering weakness in their exchange rates. Nonetheless, sensitivity of fund flows into EM fixed-income markets to EM exchange rates has diminished but has not yet outright vanished. If EM currencies depreciate further, odds are that there will be a sudden stop in capital flows into EM fixed-income markets. Outside of some basket cases, we do not expect the majority of EM governments or corporations to default on their debt. Yet, we foresee further meaningful EM currency depreciation which will simply raise the cost of servicing foreign currency debt. It would be natural for sovereign and corporate credit spreads to widen as they begin pricing in diminished creditworthiness among EM debtors in foreign currency terms.     Bottom Line: Unlike EM equities, EM fixed-income markets are a crowded trade and are overbought. Hence, any selloff in these markets could trigger an exodus of capital pushing up their yields. Rising yields will in turn push EM equities over the cliff. EM Currencies: More Downside We expect EM currencies to continue depreciating. EM ex-China currencies’ total return index (including carry) versus the US dollar is breaking down (Chart I-8, top panel). This is occurring despite the plunge in US interest rates. Notably, as illustrated in the bottom panel of Chart I-8, EM ex-China currencies have not been correlated with US bond yields. The breakdown in correlation between EM exchange rates and US interest rates is not new. This means that the Fed's easing will not prevent EM currency depreciation. EM currencies correlate with commodities prices generally and industrial metals prices in particular (Chart I-9, top panel). The latter has formed a head-and-shoulders pattern and has broken down (Chart I-9, bottom panel). The path of least resistance for industrial metal prices is down. Chart I-8More downside In EM Ex-China Currencies Chart I-9A Breakdown In Commodities Points To A Relapse In EM Currencies Chart I-10Chinese Imports Are Key To EM Currencies EM currencies’ cyclical fluctuations occur in-sync with global trade and Chinese imports (Chart I-10). Both will stay very weak for now. Finally, China is stimulating, and we believe the pace of stimulus will accelerate. However, the measures announced by the authorities so far are insufficient to project a rapid and lasting growth recovery. In particular, the most prominent measure announced in China is the PBoC’s special re-lending quota of RMB 300 billion to enterprises fighting the coronavirus outbreak. However, this amount should be put into perspective. In 2019, private and public net credit flows were RMB 23.8 trillion, and net new broad money (M2) creation was RMB 16 trillion. Thus, this re-lending quota will boost aggregate public and private credit flow by only 1.2% and broad money flow by mere 2%. This is simply not sufficient to meaningfully boost growth in China. Notably, daily, commodities prices in China do not yet confirm any growth recovery (Chart I-11). Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Bottom Line: The selloff in EM exchange rates will persist. As discussed above, this will likely lead to outflows from both EM credit markets and domestic bonds. Reading Markets’ Tea Leaves It is impossible to forecast the pace and scope of the spread of COVID-19 as well as the precautionary actions taken by consumers and businesses around the world. In brief, it is unfeasible to assess the COVID-19’s impact on the global economy. The direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Rather than throwing darts with our eyes closed, we examine profiles of various financial markets with the goal of detecting subtle messages that financial markets often send: Aggregate EM small-cap and Chinese investable small-cap stocks seem to be breaking down (Chart I-12). Chart I-11Daily Commodities Prices In China: No Sign Of Revival Chart I-12Investable Small Cap Stocks Seem To Be Breaking Down   The technical profiles of various EM currencies versus the US dollar on a total return basis (including the carry) are consistent with a genuine bear market (Chart I-13). Hence, their weakness has further to go. Global industrial stocks’ relative performance against the global equity benchmark has broken below its previous technical support (Chart I-14). This is a bad omen for global growth. Chart I-13EM Currencies Are In A Genuine Bear Market Chart I-14A Breakdown In Global Industrials Relative Performance   Finally, Korean tech stocks as well as the Nikkei index seem to have formed a major top (Chart I-15). This technical configuration suggests that their relapse will very likely last longer and go further. Chart I-15A Major Top in Korean And Japanese Stocks? All these signposts relay a downbeat message on global growth and, consequently, EM risk assets and currencies. A pertinent question to ask is whether the currently extremely high level of the VIX is a contrarian signal to buy stocks? Investors often buy the VIX to hedge their underlying equity portfolios from short-term downside. However, when and as they begin to view the equity selloff as enduring, they close their long VIX positions and simultaneously sell stocks. In brief, the VIX’s current elevated levels are likely to be a sign that many investors are still long stocks. When investors trim their equity holdings, they will likely also liquidate their long VIX positions. Thereby, share prices could drop alongside a falling VIX. Therefore, we are using the recent surge in equity volatility to close our long position in implied EM equity volatility. Even though risks to EM share prices are still skewed to the downside, their selloff may not be accompanied by substantially higher EM equity volatility. However, we continue to recommend betting on higher implied volatility in EM currencies. The latter still remains very low. Investment Conclusions We reinstated our short position on the EM equity index on January 30, and this trade remains intact. For global equity portfolios, we continue to recommend underweighting EM versus DM. Within the EM equity universe, our overweights are Korea, Thailand, Russia, central Europe, Mexico, Vietnam, Pakistan and the UAE. Our underweights are Indonesia, the Philippines, South Africa, Turkey and Colombia. We are contemplating downgrading Brazilian equities from neutral to underweight. The change is primarily driven by our downbeat view on banks (Chart I-16). This is in addition to our existing bearish view on commodities. We will publish a Special Report on Brazilian banks in the coming weeks. Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Among the EM equity sectors, we continue to recommend a long EM consumer staples/short banks trade (Chart I-17, top panel) as well as a short both EM and Chinese banks versus their US peers positions (Chart I-17, middle and bottom panels). Chart I-16Brazilian Bank Stocks Are Breaking Down? Chart I-17Our Favored EM Equity Sector Bets   We continue to recommend a short position in a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. We are also structurally bearish on the RMB. Today we are booking profits on the short Colombian peso / long Russian ruble trade (please refer to section on Colombia on pages 13-17). With respect to EM local currency bonds and EM sovereign credit, our overweights are Mexico, Russia, Colombia, Thailand, Malaysia and Korea. Our underweights are South Africa, Turkey, Indonesia, and the Philippines. The remaining markets warrant a neutral allocation. As always, the list of recommendations is available at end of each week’s report and on our web page. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Colombia: Upgrade Domestic Bonds; Take Profits On Short Peso Trade Chart II-1Oil Makes A Huge Difference To Colombia's Current Account Today we recommend upgrading local currency bonds and booking profits on the short Colombian peso / long Russian ruble trade. The reason is tight fiscal and monetary policies are positive for bonds and the currency. Although we are structurally bullish on Colombia’s economy, we remain underweight this bourse relative the EM equity benchmark. The primary reason is the high sensitivity of Colombia’s balance of payments to oil prices. In particular, oil accounts for a large share (40%) of Colombia’s exports. As of Q4 2019, the current account deficit was $14 billion or 4% of GDP with oil, and $25 billion or 7.5% of GDP excluding oil (Chart II-1). In short, each dollar drop in oil prices substantially widens the nation’s current account deficit and weighs on the exchange rate. Besides, the current hawkish monetary stance and overly tight fiscal policy will produce a growth downtrend. The Colombian economy has reached a top in its business cycle: The flattening yield curve is foreshadowing a major economic slowdown (Chart II-2, top panel). Our proxy for the marginal propensity to spend for businesses and households leads the business cycle by about six months and is presently indicating that growth will roll over soon (Chart II-2, bottom panel). Moreover, the corporate loan impulse has already relapsed, weighing on companies’ capital expenditures (Chart II-3).  Chart II-2The Business Cycle Has Peaked Chart II-3Investment Expenditures Heading South   The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. The primary fiscal balance has surged to above 1% of GDP as primary fiscal expenditures have stagnated in nominal terms and shrunk in real terms last year (Chart II-4). In regards to monetary policy, the prime lending rate is 12% in nominal and 8.5-9% in real (inflation-adjusted) terms. Such high borrowing costs are restrictive as evidenced by several business cycle indicators that are in a full-fledged downtrend: manufacturing production, imports of consumer and capital goods, vehicle sales and housing starts (Chart II-5). Chart II-4Hawkish Fiscal Policy Chart II-5The Economy Is In The Doldrums Chart II-6Consumer Spending Has Been Supported By Borrowing Overall, economic growth has been held up solely by very robust household spending, which accounts for 65% of GDP. Critically, consumer borrowing has financed such buoyant consumer expenditures (Chart II-6). However, the pace of household borrowing is unsustainable with consumer lending rates at 18%. Moreover, nominal and real (deflated by core CPI) wage growth are decelerating markedly and hiring will slow down in line with reduced capital spending.  Besides, disinflationary dynamics in this country will be amplified due to the massive influx of immigration from Venezuela in the past two years. Currently, the number of immigrants from the neighboring country stands at 1.4 million people, or 5% of Colombia’s labor force. Such an enormous increase in labor supply introduces deflationary pressures in the Colombian economy by depressing wage growth. Therefore, despite the depreciating currency, core measures of inflation will likely drop to the lower end of the central bank’s target range in next 18-24 months. Investment Recommendations The economy is heading into a cyclical slump but monetary and fiscal policies will remain restrictive. Such a backdrop is bullish for the domestic bond market and structurally, albeit not cyclically, positive for the currency. We have been recommending fixed-income investors to bet on a yield curve flattening by receiving 10-year and paying 1-year swap rates. This trade has returned 77 basis points since its initiation on January 17, 2019. Given the central bank will stay behind the curve, this strategy remains intact. Today we recommend upgrading Colombian local currency bonds from neutral to overweight. Further currency depreciation and an exodus by foreign investors remain a risk. However, on a relative basis – versus its EM peers – this market is attractive. The share of foreign ownership of local currency government bonds in Colombia is 25%, smaller than in many other EMs. Additionally, Colombian bond yields are 80 basis points above the J.P. Morgan EM GBI domestic bonds benchmark and its currency is one standard deviation below its fair value (Chart II-7). We are also overweighting Colombian sovereign credit within an EM credit portfolio. Fiscal policy is very tight and government debt is at a manageable 50% of GDP. The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. Continue to underweight Colombian equities relative to the emerging markets benchmark. We will be looking for a final capitulation in the oil market to upgrade this bourse. Finally, we are booking profits on our short COP versus RUB trade, which has returned a 19% gain since May 31, 2018 (Chart II-8). As mentioned earlier, the peso has already cheapened a lot according to the real effective exchange rate based on unit labor costs (Chart II-7). Meanwhile, Colombia’s macro policy mix is positive for the currency. Chart II-7The Colombian Peso Has Depreciated Substantially Chart II-8Taking Profits On Our Short COP / Long RUB Trade   In contrast, Russia is relaxing its fiscal policy – which is marginally negative for the ruble – and the currency has become a crowded trade. Juan Egaña Research Associate juane@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chart 1Making New Lows While the number of daily new COVID-19 cases is falling in China, the virus is spreading rapidly to the rest of the world. It is now clear that the outbreak will not be contained, though much uncertainty remains about the magnitude and duration of the global economic fallout. US bond yields have dropped dramatically, with the 10-year yield threatening to break below 1% for the first time ever (Chart 1). Interest rate markets are also pricing-in a rapid Fed response, with more than 100 bps of rate cuts priced for the next year and a 50 bps rate cut discounted for March. On Friday, BCA released a Special Alert making the case that stock prices have fallen enough to buy the market, even on a tactical (3-month) horizon. It is too early to make a similar call looking for higher bond yields. While risk assets will get near-term support from a dovish monetary policy shift, bond yields will stay low (and could even fall further) until global economic recovery appears likely. On a 12-month horizon, our base case scenario is that the Fed will not have to deliver the 110 bps of cuts that are currently priced. We therefore expect bond yields to be higher one year from now. But investors with shorter time horizons should wait before calling the bottom in yields.  Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 176 basis points in February, dragging year-to-date excess returns down to -255 bps. Coronavirus fears pushed spreads wider in February, and the average spread for the overall investment grade index moved back above our cyclical target (Chart 2).1 As for specific credit tiers, Baa spreads are 9 bps above target and Aa spreads are 3 bps cheap. A-rated spreads are sitting right on our target, and Aaa debt remains 5 bps expensive. Looking beyond the economic fallout from the coronavirus, accommodative monetary conditions remain the key support for corporate bonds. Notably, both the 2-year/10-year and 3-year/10-year Treasury slopes steepened in February, and both remain firmly above zero. This suggests that the market believes that the Fed will keep policy easy. As we discussed two weeks ago, restrictive Fed policy – as evidenced by an inverted 3-year/10-year Treasury curve and elevated TIPS breakeven inflation rates – is required before banks choke off the supply of credit, causing defaults and a bear market in corporate spreads.2 Bottom Line: Corporate spreads will keep widening until coronavirus fears abate, but COVID-19 will not cause the end of the credit cycle. Once the dust settles, a buying opportunity will emerge in investment grade corporates, with spreads back above our cyclical targets. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 271 basis points in February, dragging year-to-date excess returns down to -379 bps. The junk index spread widened 110 bps on the month and is currently 37 bps below its early-2019 peak. Ex-energy, the average index spread widened 93 bps in February. It is 71 bps below its 2019 peak. High-yield spreads were well above our cyclical targets prior to the COVID-19 outbreak and have only cheapened further during the past month. More spread widening is likely in the near-term, but an exceptional buying opportunity will emerge once virus-related fears fade. This is especially true relative to investment grade corporate bonds. To illustrate the valuation disparity between investment grade and high-yield, we calculated the average monthly spread widening for each credit tier during this cycle’s three major “risk off” phases (2011, 2015 and 2018). We then used each credit tier’s average option-adjusted spread and duration to estimate monthly excess returns for that amount of spread widening (Chart 3, bottom panel). The results show that, in past years, Baa-rated corporates behaved much more defensively than Ba or B-rated bonds. But now, because of the greater spread cushion and lower duration in the junk space, estimated downside risk is similar. In other words, the valuation disparity between investment grade and junk means that investment grade corporates offer much less downside protection than usual compared to high-yield. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in February, dragging year-to-date excess returns down to -60 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, driven by a 7 bps widening of the option-adjusted spread that was partially offset by a 6 bps reduction in expected prepayment losses (aka option cost). The 10-year Treasury yield has made a new all-time low, and the 30-year mortgage rate – at 3.45% – is only 14 bps above its own (Chart 4). At these levels, an increase in mortgage refinancing activity is inevitable, and indeed, the MBA Refi index has bounced sharply in recent weeks. MBS spreads, however, have not yet reacted to the higher refi index (panel 3). The nominal spread on 30-year conventional MBS is only 9 bps above where it started the year, and expected prepayment losses are 5 bps lower.3 Some widening is likely during the next few months, and we recommend that investors reduce exposure to Agency MBS. Even on a 12-month horizon, MBS spreads offer good value relative to investment grade corporate bonds for now (bottom panel), but investment grade corporates will cheapen on a relative basis if the current risk-off environment continues. This is probably a good time to start paring exposure to MBS, with the intention of re-deploying into corporate credit when spreads peak. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 86 basis points in February, dragging year-to-date excess returns down to -99 bps. Sovereign debt underperformed duration-equivalent Treasuries by 270 bps in February, dragging year-to-date excess returns down to -367 bps. Foreign Agencies underperformed the Treasury benchmark by 162 bps on the month, dragging year-to-date excess returns down to -189 bps. Local Authority debt underperformed Treasuries by 14 bps in February, dragging year-to-date excess returns down to +47 bps. Domestic Agency bonds underperformed by 5 bps in February, dragging year-to-date excess returns down to -7 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +7 bps. We continue to see little value in USD-denominated Sovereign debt, outside of Mexico and Saudi Arabia where spreads look attractive compared to similarly-rated US corporate bonds (Chart 5). The Local Authority and Foreign Agency sectors, however, offer attractive combinations of risk and reward according to our Excess Return Bond Map (see Appendix C). Our Global Asset Allocation service just released a Special Report on emerging market debt that argues for favoring USD-denominated EM sovereign debt over both USD-denominated EM corporate debt and local-currency EM sovereign bonds.4 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 80 basis points in February, dragging year-to-date excess returns down to -114 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 11% on the month to 88%, remaining below its post-crisis mean (Chart 6). For some time we have been advising clients to focus municipal bond exposure at the long-end of the Aaa curve, where yield ratios were above average pre-crisis levels. But last month’s sell-off brought some value back to the front end (panel 2). Specifically, the 2-year, 5-year and 10-year M/T yield ratios are all back above their average pre-crisis levels at 85%, 83% and 86%, respectively. 20-year and 30-year maturities are still cheapest, at yield ratios of 93% and 94%, respectively. Investors should adopt a laddered allocation across the municipal bond curve, as opposed to focusing exposure at the long-end. Fundamentally, state and local government balance sheets remain solid. Our Municipal Health Monitor is in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both trends are consistent with muni ratings upgrades continuing to outpace downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-steepened dramatically in February, with yields down at least 30 bps across the board. The 2/10 Treasury slope steepened 9 bps on the month, reaching 27 bps. The 5/30 slope also steepened 9 bps to reach 76 bps. February’s plunge in yields was massive, but the fact that it occurred without 2/10 or 5/30 flattening signals that the market expects the Fed to respond quickly and that any economic pain will be relatively short lived. In fact, the front-end of the curve is now priced for 110 bps of rate cuts during the next 12 months (Chart 7). That amount of easing would bring the fed funds rate back to 0.48%, less than two 25 basis point increments off the zero lower bound. Though the drop in 12-month rate expectations didn’t move the duration-matched 2/5/10 or 2/5/30 butterfly spreads very much, the 5-year note remains very expensive relative to both the 2/10 and 2/30 barbells (bottom 2 panels). The richness in the 5-year note will reverse if the Fed delivers less than the 110 bps of rate cuts that are currently priced for the next year. At present, we view less than 110 bps of easing as the most likely scenario, and therefore maintain our position long the 2/30 barbell and short the 5-year bullet. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 159 basis points in February, dragging year-to-date excess returns down to -232 bps. The 10-year TIPS breakeven inflation rate fell 24 bps to 1.42%. The 5-year/5-year forward TIPS breakeven inflation rate fell 21 bps to 1.50%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s inflation target. We have been recommending that investors own TIPS breakeven curve flatteners on the view that inflationary pressures will first show up in the realized inflation data and the short-end of the breakeven curve, before infecting the long-end.5 However, recent risk-off market behavior has caused long-end inflation expectations to fall dramatically, while sticky near-term inflation prints have supported short-dated expectations. Case in point, the 2-year TIPS breakeven inflation rate declined 16 bps in February, compared to a 24 bps drop for the 10-year (Chart 8). Inflation curve flattening could continue in the near-term but will reverse when risk assets recover. As a result, we recommend taking profits on TIPS breakeven curve flatteners and waiting for a period of re-steepening before putting the trade back on. Fundamentally, we note that the 10-year TIPS breakeven inflation rate is 38 bps cheap according to our re-vamped Adaptive Expectations Model (bottom panel).6 Investors should remain overweight TIPS versus nominal Treasuries on a 12-month horizon. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +26 bps. The index option-adjusted spread for Aaa-rated ABS widened 7 bps on the month. It currently sits at 33 bps, right on top of its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS ranks among the most defensive US spread products. This explains why the sector has weathered the recent storm so well, and why it is actually up versus Treasuries so far this year. ABS also offer higher expected returns than other low-risk spread sectors such as Domestic Agency bonds and Supranationals. For as long as the current risk-off phase continues, consumer ABS are a more attractive place to hide than Domestic Agencies or Supranationals. However, once risk-on market behavior re-asserts itself, consumer ABS will once again lag other riskier spread products. In the long-run, we also remain concerned about deteriorating consumer credit fundamentals, as evidenced by tightening lending standards for both credit cards and auto loans, and a rising household interest expense ratio (bottom 2 panels). Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 42 basis points in February, dragging year-to-date excess returns down to +1 bp. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 9 bps on the month. It currently sits at 76 bps, below its average pre-crisis level (Chart 10). In a recent Special Report, we explored how low interest rates have boosted commercial real estate (CRE) prices this cycle and concluded that a sharp drawdown in CRE prices is likely only when inflation starts to pick up steam.7 In that report we also mentioned that non-agency Aaa-rated CMBS spreads look attractive relative to US corporate bonds in risk-adjusted terms (Appendix C), and that the macro environment is close to neutral for CMBS spreads. Both CRE lending standards and loan demand were close to unchanged during the past quarter, as per the Fed’s Senior Loan Officer Survey (bottom 2 panels).  Agency CMBS: Overweight Agency CMBS performed in line with the duration-equivalent Treasury index in February, leaving year-to-date excess returns unchanged at +35 bps. The index option-adjusted spread widened 2 bps on the month to reach 56 bps. Agency CMBS offer greater expected return than Aaa-rated consumer ABS, while also carrying agency backing (Appendix C). An overweight allocation to this sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 110 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 28, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of February 28, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 50 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 50 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of February 28, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more information on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “The Credit Cycle Is Far From Over”, dated February 18, 2020, available at usbs.bcaresearch.com 3 Expected prepayment losses (or option cost) are calculated as the difference between the index’s zero-volatility spread and its option-adjusted spread. 4 Please see Global Asset Allocation Special Report, “Understanding Emerging Markets Debt”, dated February 27, 2020, available at gaa.bcaresearch.com 5 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com  6 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 7 Please see US Investment Strategy / US Bond Strategy Special Report, “Commercial Real Estate And US Financial Stability”, dated January 27, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Policy Responses To The Virus: Markets are now pricing in significant monetary policy easing in response to the growth shock from the COVID-19 outbreak and related financial market instability. It is not yet clear, however, that central banks will NOT ease by as much as currently discounted in the low level of bond yields – especially as risk assets will riot anew if policymakers are not dovish enough. Duration: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the virus. Spread Product: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates. Feature What a wild ride it has been for investors. Equity markets worldwide corrected sharply last week as investors were forced to downgrade global growth expectations with the COVID-19 outbreak spreading more rapidly outside of China. US equities were particularly savaged with the S&P 500 shedding -11% of its value in a mere five trading sessions, with the VIX index of implied equity volatility spiking over 40, evoking comparisons to some of the darkest days of the 2008 financial crisis. Chart of the WeekCOVID-19 Concerns Causing Market Jitters Government bond yields have collapsed alongside plunging equity values, with the benchmark 10-year US Treasury yield hitting an all-time intraday low of 1.04% yesterday. Investors are betting on aggressive rate cuts by global central bankers to offset weak growth momentum and disinflationary pressures that were already in place before the arrival of COVID-19. At the same time, corporate credit spreads widened worldwide last week, but the moves were relatively subdued and do not signal growing concern over future default losses (Chart of the Week). In this report, we discuss how to best position a global bond portfolio given these competing messages from government bond and credit markets. We conclude that maintaining selective strategic (6-12 months) overweights in global spread product versus governments, while also maintaining a neutral tactical (0-3 months) overall duration exposure - as a hedge against a more “U-shaped” recovery from the virus-driven downturn in global growth - is the best way to position for a backdrop where policymakers will need to be as easy as possible in a more uncertain world. What To Do Next On … Duration Risk assets were staging a massive rebound yesterday as we went to press, after policymakers worldwide signaled the need for stimulus measures to offset the COVID-19 growth shock. Both Fed Chairman Jerome Powell and Bank of Japan (BoJ) Governor Haruhiko Kuroda promised to ease monetary policy, if necessary, to stabilize markets. Meanwhile, looser fiscal policy may finally be on the way in Europe. The government of virus-stricken Italy announced a €3.6 billion stimulus package, while the German Finance Minister has hinted at a temporary suspension of Germany’s constitutional “debt brake” on deficit spending. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus. A true coordinated global easing of both monetary and fiscal policy, would be very bullish for beaten-down growth-sensitive assets like equities and industrial commodities that have been focused on the shutdown of China’s economy in February to combat the spread of the virus (Chart 2). It’s a different story for government bonds, however, as a rebound in yields from current depressed levels is not assured, even if monetary policy is eased further. This is because central bankers must maintain a dovish bias until the virus-driven uncertainty over global growth begins to fade, or else risk assets will riot once again. It’s all about financial conditions now, especially in the US where COVID-19 and the stock market selloff have become front-page news in a presidential election year. Chart 2How Quickly Will China Rebound? For example, the entire US Treasury curve now trades below the mid-point of the fed funds target range, with the market now pricing in a very rapid dovish move by the Fed (Chart 3). Chart 3A Big Grab For Global Duration Yield curves are now very flat in other major developed market (DM) economies, as well. This is partly due to the risk aversion bid for safe assets, which is evident in the deeply negative term premium component of bond yields. Flat curves also reflect a more long-lasting component, with markets pricing in lower equilibrium rates in the future. Investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 4Markets Increasingly Pricing In Global ZIRP Our simple proxy for the market expectation of the nominal terminal rate- the 5-year overnight index swap (OIS) rate, 5-years forward – is between 0-1% for all major DM countries (Chart 4). The implication is that investors are not only demanding immediate rate cuts to boost growth and stabilize financial markets, but also see little chance of those cuts eventually being reversed in the future. Chart 5Our Central Bank Monitors Say More Easing Is Needed Chart 6Global Yields Reflect Dovish Rate Expectations At the moment, our global Central Bank Monitors – a compilation of economic and financial variables that influence monetary policy decisions – are all signaling a need for rate cuts (Chart 5). This is a function of sluggish growth & weak inflation. The plunge in global government bond yields already reflects that dovish shift in market expectations for central banks. Our 12-month discounters, which measure the expected change in short-term interest rates over the next year as extracted from OIS curves, are all priced for lower policy rates in the US (-97bps as of last Friday’s close), the euro area (-15bps) the UK (-35bps), Japan (-17bps), Canada (-72bps) and Australia (-46bps) (Chart 6). In the US, the current level of the benchmark 10-year Treasury yield is consistent with the extended slump in US industrial activity – as measured by the fall in the ISM manufacturing index – and risk-off sentiment measures like the CRB Raw Industrials/Gold price ratio (Chart 7). Yet at the same time, financial conditions remain very accommodative despite last week’s selloff, suggesting that the US economy can potentially weather a bout of COVID-19 uncertainty – as long as the Fed does not disappoint by delivering fewer rate cuts than the market is demanding and creating another down leg in the equity market. Chart 7UST Yields Need To Stay Lower For Longer Outside the US, other central banks that have non-zero policy rates – like the Bank of Canada, Reserve Bank of Australia and Bank of England – can deliver on the rate cuts discounted in their OIS curves to fight a COVID-19 global growth downturn, if needed. Chart 8UST Bullishness Still Not At Historical Extremes The negative rate club of the ECB and BoJ, however, is far less likely to actually cut rates and will rely on greater asset purchases and forward guidance to try and provide more policy stimulus. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. So what should a bond investor do with duration exposure? It is a difficult call with so many uncertainties on global growth momentum, the spread of the virus outside China, the size of any monetary or fiscal policy stimulus measures, and the degree of risk aversion still evident in financial markets. We prefer to view duration exposure – on a tactical basis – as a hedge to owning risk assets like corporate bonds, where we see some value now opening up after last week’s selloff, rather than a way to express a directional view on interest rates where we have less visibility and conviction. Therefore, we are raising our recommended overall duration exposure to neutral this week on a tactical basis. At the same time, we are maintaining an underweight stance on government bonds versus an overweight on corporate debt. We think a true bottom in yields will be reached when there are more decisive signs that bond positioning has reached a bullish extreme, according to indicators like the JP Morgan duration survey and the Market Vane US Treasury bullish sentiment index (Chart 8). In our model bond portfolio, we are expressing that extension of duration by shifting exposure from shorter maturity buckets to longer duration buckets in most countries. While also increasing exposure to “higher-beta” government bond markets like the US and Canada, at the expense of lower-beta Japanese government bonds. Bottom Line: Raise overall global duration exposure to neutral on a tactical basis (0-3 months) until there is greater clarity on the full magnitude of the hit to global growth from the COVID-19 outbreak. Increase allocations to countries with higher yield betas, like the US and Canada, at the expense of low-beta markets like Japan. What To Do Next On … Spread Product Allocations Chart 9US HY Selloff Was Focused On Energy Names Last week’s equity market meltdown did spill over into corporate bond markets, with credit spreads widening for both investment grade and high-yield corporate debt in the US and Europe. In the US, however, the jump in high-yield spreads was particularly acute among Energy names, with the index option-adjusted spread (OAS) climbing over 1000bps as oil prices plunged (Chart 9). US high-yield ex-energy has been relatively more stable, with the spread climbing to 436bps, despite the surge in equity volatility. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield. Stepping back and looking at US investment grade and high-yield corporates, more broadly, last week’s selloff has restored some value, most notably in high-yield.  According to our framework for calculating spread targets for global credit, last week’s selloff pushed US investment grade spreads back to our spread targets from very expensive levels (Chart 10).1 Baa-rated US investment-grade moved slightly above our spread target, but we would describe investment grade spreads as now overall fairly valued. US high-yield spreads, on the other hand, have widened well in excess of our spread targets across all credit rating tiers (Chart 11). Chart 10US Investment Grade Spreads Now Fairly Valued Chart 11US High-Yield Spreads Look Very Cheap In our framework, the spread targets are determined by looking at 12-month breakeven spreads – the amount of spread widening necessary to eliminate the yield cushion of owning corporates over government bonds on a one-year horizon – relative to their long-run history. We group those spreads according to phases of the monetary policy cycle, as defined by the slope of the US Treasury yield curve. The spread target is then calculated based on the median breakeven spread for that phase of the cycle. Currently, we are in “Phase 2” of the policy cycle, which means that the Treasury yield curve (10-year minus 3-year) is positively sloped between 0 and 50bps. In Charts 10 & 11, we add a new wrinkle to our existing way to present the spread targets. We also calculate the targets using the 25th and 75th percentile observations for the breakeven spreads for that phase of the monetary policy cycle. This gives us a range for the spread target that encompasses more of the historical data. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. The spread widening in US high-yield has very clearly restored value to spreads, which are well above the upper level of our spread target range. The same cannot be said for US investment grade, where spreads are in the middle of the target range. Chart 12European Corporates Now Offer Better Value Based on this analysis, we remain comfortable in maintaining our neutral recommended stance on US investment grade corporates and overweight stance on US high-yield. Given the improved valuations in US junk bonds, however, we think increasing allocations in our model bond portfolio makes sense. Thus, this week, we are adding to our recommended high-yield exposure (see Page 12). That increased allocation is “funded” by reducing our US Agency MBS exposure from overweight to neutral. Our colleagues at BCA Research US Bond Strategy are concerned that MBS spreads are likely to widen in the next few months to reflect the higher prepayment risk from the recent steep fall in US mortgage rates. One final note: our spread target framework for euro area corporates also indicates that last week’s global risk-off event also restored some value to European credit (Chart 12). Thus, we are maintaining our recommended overweights for both euro area investment grade and high-yield. Bottom Line: The widening of global corporate bond spreads during last week’s equity market correction was relatively modest, suggesting that the COVID-19 outbreak has not become a credit event that raises downgrade/default risks. Maintain an overall overweight allocation to global corporates versus government bonds. Downgrade US MBS to neutral, however, given the risk of higher prepayments from falling mortgage rates.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We presented our framework for calculating global corporate spread targets, which builds on the work from our US Bond Strategy sister service, back in January. Please see BCA Research Global Fixed Income Strategy Special Report, "How To Find Value In Global Corporate Bonds", dated January 21, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature “Bayesian: …statistical methods that assign probabilities or distributions to events…based on experience or best guesses before experimentation and data collection and that apply Bayes' theorem to revise the probabilities and distributions after obtaining experimental data.” — Merriam-Webster Dictionary Markets have reacted pretty rationally to the outbreak of the COVID-19 virus. Equities initially rebounded a few days ahead of the peak of new cases in China (Chart 1). But then, once the number of cases in the rest of the world started to accelerate, stock markets sold off again sharply. The MSCI All Country World Index is now down 13% from its peak on February 12. Recommended Allocation Chart 1Markets Have Reacted In Line With New COVID-19 Cases No one knows whether this episode will turn into an unprecedented pandemic, which will kill millions worldwide, last for months, and trigger a global recession. So it is the sort of environment in which Bayesian analysis becomes useful. Our “prior” for the probability of a full pandemic would be around 10-20%. If it doesn’t happen, an attractive buying opportunity for risk assets should present itself soon. But there could be further downside first, especially if the number of cases in major countries such as the US, Germany, and the UK were to accelerate significantly. There are some sign that Chinese activity is beginning to recover. There are some signs that Chinese activity is beginning to recover, as new cases of COVID-19 slow, thanks to the draconian measures taken by the authorities. Big Data can help analyze this. For example, live traffic statistics from TomTom show that by February 28, weekday road congestion in Shanghai was back to 50% of its normal level, compared to 19% on February 14 (Chart 2). The Chinese authorities have relaunched fiscal and monetary stimulus, causing short-term rates to fall to their lowest level since 2010 (Chart 3). Monetary policy has been upgraded from “prudent” to “flexible and moderate.” BCA Research’s China strategists believe there is even an increasing possibility of a stimulus overshoot in the next 6-12 months, as the authorities plan for the worst-case scenario but the economy rebounds.1 Chart 2Chinese People Getting Back On The Roads Chart 3Chinese Stimulus Pushing Down Rates In the short-term, it is clear that global growth will weaken, though quantifying this is hard. A 1% quarter-on-quarter decline in Chinese GDP in Q1 would bring growth down to 3.5% year-over-year. Our colleagues in BCA’s Global Investment Strategy estimate this would cause global growth to fall 0.8% below trend in Q1, mainly from a contraction in tourism, but that this would be largely made up in Q2, assuming that the epidemic is over by then (Chart 4).2 Could even a limited epidemic tip the world into recession? We doubt it. Consumer confidence remains strong in developed economies (Chart 5) and the virus is not yet serious enough to stop most consumers going out to spend. The global economy was in the process of bottoming out before COVID-19 hit (Chart 6) and there is little reason to think that we will not return to the status quo ante. Chart 4Global Growth To Slow In Q1, But Rebound In Q2   Chart 5Consumers Remain Confident Chart 6Before COVID-19, Growth Was Bottoming Out We see the two biggest risks being: 1) a rise in defaults in China, especially among smaller companies, that the government is unable or unwilling to prevent (Chart 7); and 2) a deterioration in the jobs market in the US, as companies start to postpone hiring, or lay off staff (Chart 8). We will watch these carefully over coming weeks. Chart 7Are Chinese Companies Vulnerable? Chart 8Is The US Job Market Starting To Wobble? Chart 9Markets Believe Trump Would Beat Sanders There is one other risk that might give equity markets an excuse for a further sell-off: November’s US presidential election. The probability that Bernie Sanders wins the Democratic nomination has risen to 60% from 15% over the past two months. The consensus believes that Trump can easily defeat Sanders, which is why the President’s probability of being reelected has risen in tandem (Chart 9). But, if the economy starts to weaken and Trump’s approval rating slips, investors could become nervous about the likelihood of a market-unfriendly Sanders administration. We would not recommend long-term investors sell out of risk assets at this point. There could be an attractive buying opportunity over the next few weeks, and investors who have derisked should be looking for a reentry point. With US 10-year bonds yields at 1.2% and German yields at -60 basis points, it is hard to see much further upside for risk-free bonds. Equities should be able to outperform over the next 12 months, as growth rebounds following the COVID-19 episode. We have been recommending overweights in cash and gold, as hedges, since December, and these still make sense. However, if events over the coming weeks point to the risk of global pandemic being higher than we currently think, then investors should Bayesianally adjust and move more risk-off. Otherwise, a peak in COVID-19 cases ex-China should be a strong signal to buy risk assets again. Chart 10Why Should Long-Run Inflation Expectations Fall? Fixed Income: US Treasurys have become investors’ safe haven of choice over the past few weeks. A marked drop in long-run inflation expectations (Chart 10), in particular, has pushed the 10-year yield to a record low. This seems somewhat illogical, since the Fed will announce this summer the results of its review of monetary policy, which is likely to lead to a more dovish long-term inflation target (perhaps a commitment to achieve 2% on average over the cycle). The market has also priced in at least three Fed rate cuts by year-end (Chart 11). The Fed will certainly cut rates if US growth falters as a result of COVID-19, but this is by no means a certainty. History shows that Treasury yields jumped sharply once previous viral outbreaks ended (Chart 12). We expect yields to be significantly higher in 12 months, and so are underweight duration and prefer TIPS over nominal bonds. Credit will continue to underperform in the risk-off phase, but some interesting opportunities should arise soon, especially among the lowest-rated credits and in the Energy sector. Chart 11Will The Fed Really Be This Accommodating? Chart 12After Previous Virus Outbreaks, Rates Leapt Equities: The sell-off has already put on fire sale some stocks most affected by the epidemic. For example, cruise lines are down by 40% over the past month or so, European oil stocks 25%, some luxury goods makers 30%, and airlines 30%. Opportunistic investors might want to buy a basket of the most oversold quality names. Our overweight on euro area stocks has not worked in the sell-off. But, as a cyclical, export-oriented market, we continue to expect Europe to outperform when global growth rebounds. Euro area banks, in particular, represent the best call option on a rise in bond yields, since their performance is highly correlated to the shape of the yield curve. We continue to have a somewhat cyclical tilt among our sector weightings (with overweights on, for example, Energy and Industrials), but may adjust this in our Quarterly Portfolio Outlook in early April if we decide to reduce risk. The sell-off has already put on fire sale some stocks most affected by the epidemic. Currencies: The dollar is a safe-haven currency and so, unsurprisingly, has benefitted from the rush to safety in recent weeks. However, it remains overvalued (Chart 13), and interest rate differentials would move further against it if the Fed does cut rates, since other major developed central banks have much less room to move (Chart 14). This suggests that it will probably resume the weakness it experienced from August to December last year as soon as global growth rebounds. Chart 13Dollar Is Overvalued... Chart 14...And Interest Differentials Have Moved Against It Chart 15Metals Prices Stabilized In Recent Weeks Commodities: Industrial metals fell sharply on the outbreak of COVID-19 in China, but have bottomed in line with the stabilization of the situation in that country (Chart 15). Gold has worked predictably as the best hedge in the sell-off. While it is starting to look technically overbought and would be hurt by a rise in bond yields (Chart 16), for prudent investors it remains a useful hiding place amid heightened risk and ultra-low interest rates. Oil is the commodity that has fallen the most surprisingly, with Brent close to the low it reached during the sell-off in December 2018 (Chart 17).  It is much less dependent on Chinese demand than metals are, and so is maybe pricing in a global recession – as well as questioning the commitment of OPEC to cut production further. This would suggest upside to the oil price if global growth turns out not to be so bad, oil demand continues to pick up, and supply remains constrained.   Chart 16How Much Could Gold Overshoot? Chart 17Oil Discounting A Global Recession Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?” dated 26 February 2020, available at cis.bcaresearch.com 2   Please see Global Investment Strategy Weekly Report, “Market Too Complacent About The Coronavirus,” dated 21 February 2020, available at cis.bcaresearch.com GAA Asset Allocation  

Special Report

Highlights Investors’ hunt for yield over the past few years has increasingly led them to view emerging markets debt (EMD) as an attractive component of portfolios. EMD should not be viewed as one homogeneous asset class. Investors should distinguish between its key segments: hard-currency sovereign debt, hard-currency corporate debt, and local-currency sovereign debt. EMD allows investors to own bonds with higher yields than DM sovereign or corporate bonds. But it comes with specific risks that investors need to understand. EMD, being a highly cyclical asset class, should perform well in an environment of accelerating global growth – which we expect to see during 2020. Within this asset class, we favor EM hard-currency sovereign bonds over both EM hard-currency corporate debt and local-currency sovereign bonds. However, the coronavirus outbreak makes us reluctant to pull the trigger on this recommendation now. Rather, we are placing EM hard-currency sovereign debt on upgrade watch. Feature Emerging markets debt (EMD) as an asset class has grown over the past decades to over US$24 trillion in bonds outstanding – becoming an integral part of the global investment universe, and presenting an interesting investment opportunity for investors. The EMD universe, which was previously dominated by sovereign issues in hard currencies, has become more diverse, and consequently, difficult for investors to ignore. In this Special Report, we identify the segments that make up EMD and the various exposures that investors face when allocating to it. We analyze their risk-return characteristics and the drivers contributing to their returns, and compare EMD to other asset classes. We conclude by identifying any diversification benefits that investors can reap as the hunt for yield continues. Introduction Estimates value total debt in emerging markets at over $24 trillion as of Q2 2019. This includes both sovereign and corporate debt, in both local and hard currencies (Chart 1).1  The bulk of EMD, however, is in local currencies – almost 90%. Chart 1Estimates Of Total EMD In this Special Report, we focus on the following three segments of emerging markets debt (EMD): Sovereign debt issued in hard currency – the majority of which is USD denominated – estimated at $2 trillion. I. We distinguish between “pure”            sovereigns and quasi-sovereign bonds. Corporate debt2  issued in hard currency – mainly in USD – estimated to be $1.5 trillion. Sovereign debt issued in local currency – estimated at $10.3 trillion. We do not cover local-currency corporate debt, as more than half of it – estimated to be $8.1 trillion – is issued by Chinese firms and is hard to access for most investors. Each of these segments offers an array of opportunities, is driven by different dynamics, and bears risks that investors must recognize before allocating to it. We recommend clients view the segments of EMD as different asset classes, rather than an aggregate. Hard-Currency Debt Hard-currency EMD refers to debt issued by governments and firms in emerging markets that is denominated in a currency other than their local currency. Estimates suggest 90%-95% of total hard-currency debt is USD denominated, with the remaining in euros and yen. The main feature of hard-currency EMD is that it provides investors with protection against currency depreciation risk. Nevertheless, it is important to highlight that currency movements can affect spreads, default risk, as well as liquidity. If a country’s currency depreciates, its ability to service its foreign debt deteriorates. This is crucial, as exemplified by currency crises over the past few years in countries such as Argentina, Turkey, Egypt, and Venezuela. Hard-Currency Sovereign Debt Since 2004, EM hard-currency sovereign bond investors have enjoyed an annualized total return of 7.4%, much higher than the 3.2% from the global Treasury index. Even on a risk-adjusted return basis, the incremental performance compensates for the additional 1.7% of annualized volatility. Investing in EM hard-currency sovereigns allows investors to find higher-yielding debt than government bonds in developed economies. Since 2004, the average yield on EM hard-currency sovereign debt was 6.1%, 3.8 percentage points higher than the 2.3% on their DM counterparts. Investors received positive returns even in real terms, as inflation in DM and the US have averaged 2.2% and 2.1% respectively, since 2004 (Chart 2). This has been extremely useful, particularly in the past few years, when bond yields in many developed economies reached zero or turned negative, and investors increasingly hunted for yield. The risk profile of the aggregate EM sovereign debt index is balanced between the safer Middle Eastern economies such as Saudi Arabia, UAE, and Qatar, and the riskier Latin American economies such as Mexico, Brazil, and Argentina. Those two buckets each comprise approximately 30% of the index, with the remainder of the index split between Asia, Emerging Europe, and Africa at 17%, 11%, and 10%, respectively (Chart 3). Other portfolios are benchmarked to J.P. Morgan’s indexes where Gulf countries have very little weight. Chart 2EM USD-Sovereigns Provide Value To DM Investors Chart 3Risk Profile Of EM USD-Sovereigns We believe it is reasonable to compare hard-currency EM sovereign debt to US investment-grade bonds due to their shared characteristics. Both have comparable duration (approximately eight years) and similar credit qualities, despite EM sovereign debt being a little riskier on average than the US corporate market (Chart 4). Nevertheless, since 2004, EM sovereign hard-currency debt has outperformed US investment-grade bonds by 40% – although its outperformance has lost steam over the past few years (Chart 5). Chart 4EM USD-Sovereigns Are Slightly Riskier Than US Investment-Grade Bonds Chart 5EM USD-Sovereigns Have Outperformed US IG Bonds... This does not mean that EM debt is immune to problems.3 The cumulative average default rate of EM foreign-currency sovereign debt – while lower than US corporates – remains high and is more pronounced as one goes down the credit-rating curve (Table 1). Idiosyncratic country risks can skew the data. If one excludes Argentina – currently weighted at only 3.5% – from the index, almost 100 basis points of spread get shaved off (Chart 6). Table 1…However, Beware Of The Default Rates Chart 6Excluding Argentina, Spreads Are Much Lower Given that most of our clients invest through passive vehicles, throughout this report, we focus on the EM aggregate indexes rather than on specific countries. However, it is important to identify over/undervalued countries, given the wide-ranging risk-profile spectrum of emerging economies. By drawing a US corporate credit curve, based on credit ratings and breakeven spreads, one can spot over- or undervalued countries relative to US investment-grade bonds. Currently, the sovereign bonds of Poland, UAE, Qatar, and Saudi Arabia appear to be more attractively valued than those of Russia, Hungary, and Brazil. The charts also show the transition of these countries across time (Chart 7, A,B,C,D). Chart 7Country Selection Is Important… Chart 8...With The UAE And Saudi As Good Examples For example, South African sovereign bonds – given their current credit rating and spreads – have moved from being overvalued relative to US corporates to undervalued over the past five years. This implies a buying opportunity, or simply that they are getting cheaper ahead of a potential downgrade. For investors with less restricted mandates, country selection can be very valuable. For example, the UAE and Saudi Arabia, two highly rated economies at Aa2 and A1 respectively, trade at 23 and 30 basis points over similarly rated US corporate bonds (Chart 8). We find that EM hard-currency sovereign spreads are mainly driven by global growth cycles, something BCA Research’s Emerging Market strategists have often highlighted.4  We rely on several key indicators to gauge where we are in the cycle. These include Germany’s IFO manufacturing business expectations, global and emerging market PMIs, as well as OECD’s Leading Economic Indicators (LEI) (Chart 9). Upward moves in these indicators have historically led to a tightening in EM sovereign spreads. Chart 9Spreads Will Tighten Once Global Growth Picks Up Quasi-Sovereign Bonds Chart 10Quasi-Sovereigns Are Focused In The Energy Sector Investors need to differentiate between EM sovereign bonds and quasi-sovereign bonds. While formal definitions vary among market participants and academics, the most common definition of “quasi-sovereign” is bonds issued by an entity where the government either fully owns the institution, controls more than 50% of its equity, or has a majority of its voting rights.5 Examples of such companies include Brazil’s Petrobras, Mexico’s Pemex, and Venezuela’s PDVSA. One reason why we highlight quasi-sovereigns is the rapid growth in the amount of such debt outstanding.6 As of January 2020, the quasi-sovereign bond market has grown by over US$630 billion throughout the past decade to US$714 billion and it now makes up over 42% of the combined EM Sovereign amd Quasi-Sovereign Bloomberg Barclays index. The oil & gas sector represents over a third of quasi-sovereign entities (Chart 10). Chart 11Quasi-Sovereigns...A Defensive Play On Corporate Bonds Some investors assume that a quasi-sovereign entity would have the full backing of its government. While that is true in most cases, the majority of quasi-sovereign bonds only have an “implicit” backing from the issuer’s government, meaning that the government holds no legal liability in case of default. Dubai World, a state-owned conglomerate, was a perfect example of this during the aftermath of the Global Financial Crisis. The government stood on the sidelines as the firm went through financial distress, forcing billions of dollars of debt to be restructured.7 Given this additional level of uncertainty and corporate risk, EM quasi-sovereign bonds trade at higher spreads than their sovereign counterparts (Chart 11). Nonetheless, bonds with even the simplest implicit backing from the government are considered a more defensive play than “pure” corporate bonds, which trade at even higher spreads. Hard-Currency Corporate Debt The increase in quasi-sovereign issuance has been a big factor in the growth of the hard-currency corporate-debt universe – a segment that became of interest to investors in the early 2000s. The outstanding amount of hard-currency corporate debt has surpassed hard-currency sovereign debt, according to the Bank Of International Settlements (BIS) (Chart 1). The EM corporate debt index8 has similar sector exposure to the MSCI EM equity index. Almost 69% of the bond index is concentrated in the Industrials category,9 with the Financial/Banking and Utilities sectors making up the remaining 26% and 5%, respectively (Chart 12). The Technology sector is an exception – comprising only 5% of the corporate bond index compared to over 16% in the equity index. The country exposure, however, is less skewed to Asian economies compared to equities (Chart 13). Chart 12EM Corporates Provide Similar Sector Exposure To Equities… Chart 13…Yet With Different Country Exposure Chart 14EM Corporates: A Defensive Play On Equities...   The overlap in sector coverage can be advantageous to investors who want quasi-exposure to EM equities but with much lower volatility. The same can be said for DM corporate bonds, whose return is highly correlated to equities but with about one-third the beta.10 The correlation between EM corporate bonds and EM equities is currently close to its post-2003 average of 0.61, and the beta of EM corporate bonds to EM equities has averaged only 0.13 (Chart 14). Despite having a lower annualized return11  than EM equities, 5.6% versus 8.3%, EM corporate bonds had almost half the realized volatility, and so outperformed equities on a risk-adjusted basis. In fact, since late 2007, they have generally outperformed EM equities even in absolute terms, despite a few periods of EM equity outperformance. Like sovereigns, EM corporate bonds provided investors with a cushion against equity downside risk. For example, during the 2015/2016 slowdown in China and emerging economies, EM equities fell by almost 28%, whereas EM corporate bonds fell by only 5% (Chart 15). Chart 15...With Lower Drawdowns On a valuation basis, however, EM corporate bonds have looked unattractive relative to EM equities, providing investors with 4% real yield, compared to an equity earnings yield of 7% since 2004 (Chart 16). Nevertheless, the current level of spreads points to moderate returns for the asset class, slightly below 4% annualized over the next five years, assuming that historical default and recovery rates remain the same, and no change in spreads (Chart 17). This implies that exposure to emerging markets via corporate bonds should be more attractive than equities on a risk-adjusted basis.12 Chart 16EM Corporate Bonds Are Unattractive Compared To Equities Chart 17Forward Returns Driven By The Spread EM corporate debt is similar to its sovereign counterpart in the range of risk profiles of its constituents. Default figures vary significantly by region and during different crises. For example, the hard-currency corporate default rate for Argentinian corporates peaked at slightly over 50% during the 2001/2002 sovereign debt crisis, while for Chile and Mexico it remained below 10%. Surprisingly, default rates in emerging market corporate speculative-grade debt have on average been below those of both the US and Europe (Chart 18). Additionally, the 12-month trailing default rate for the overall EM corporate universe, as measured by Moodys’ Investors Service, at the end of 2018 was lower than for advanced economies – at 1.4% versus 1.6%.13 Chart 18Default Rates In EM Are Surprisingly Lower Than In DM Chart 19EM Corporates Suffer From Weaker Balance Sheets   EM corporate spreads are driven by a few main variables – revenue and profit growth, the business cycle, and the exchange rate. The health of EM corporates is also an important factor. This is an area of concern as corporate leverage levels have risen since 2010, and EM firms’ ability to service debt – gauged by their interest-coverage ratio – has fallen to below 2008 levels (Chart 19). Political turmoil can upset markets. Even though investors do not face the risk of currency depreciation with hard-currency debt, EM corporates with revenues mostly in local currency, face higher debt-repayment risk during a slowdown in their economies. Local-Currency Sovereign Debt Chart 20There Is Value In EM Local-Currency Bonds Emerging-market governments, to avoid foreign currency liquidity crunches, have in recent years shifted some of their debt issuance to their own currency. However, to attract investors, yields on local-currency sovereign bonds have to compensate for the added layer of currency risk as well as conventional sovereign risk. Over the lifetime of the index,14 since 2003, yields on local-currency sovereign debt have averaged 6.7%, compared to 2.5% for the US Treasury index, 2.4% for the euro area treasury index, and 0.63% for the Japanese treasury index (Chart 20). Since 2004, EM local sovereign bonds have provided investors with attractive returns. On an annualized basis, they have returned 8.4% and 6.8% in local terms and dollar terms, respectively, albeit with higher volatility than their hard-currency counterparts on a common-currency basis (Table 2). However, those returns remain higher than those of government bonds in developed economies such as Germany and Japan, both in local- currency terms and on an unhedged basis from a USD perspective. Table 2EM Local-Currency Bonds Outperforming Other DM Government Bonds In USD And Local Currency Terms Investors allocating to this segment assume a simple yet plausible notion: that EM economies will never default on debt issued in their own currency, as they can easily “print more money”. This is partially correct: default rates across rated EM sovereign local debt remain lower than for foreign-currency sovereign debt (Table 3). Table 3Default Rates: Local-Currency Debt Versus Hard-Currency Debt Most interestingly, the gap in default rates between B- and CCC-rated bonds illustrates the “near certainty” of default for low-credit-rated sovereigns ahead of time. However, proponents of the notion that governments will not default neglect the consequences those economies will suffer if they monetize public debt: currency devaluation and high inflation, which turn into weak economic growth and tightening monetary policy, leading to a further weakening in growth.  The case of Argentina between 1998 and 2002 is a perfect example of this mechanism. The economy was hurting under an uncompetitive pegged currency as well as a large debt burden. The government’s move to increase taxes, as a solution to boost government revenues, triggered a cascade of events which resulted in faltering economic growth, increased unemployment, abandonment of the currency peg, and interest rates as high as 100%, ultimately leading to Argentina’s default on its local-currency sovereign debt (Chart 21). Chart 21Argentina: A Case Study Chart 22Country Breakdown Of Local-Currency EM Sovereigns Argentina was recently removed from J.P. Morgan’s EM local-currency sovereign index due to the capital controls the authorities have instituted. As of mid-February, Mexico was the largest issuer in the index along with Indonesia, Brazil, and Thailand close behind (Chart 22). J.P. Morgan also announced that it would gradually add Chinese government bonds to its local sovereign bond indexes over a period of 10 months starting February 2020, up to the 10% country cap.15 This move is likely to push the index’s yield lower as Chinese yields are below the current yield on the index. There is some overlap between the drivers of local- and hard-currency sovereign spreads. The most important factor for investors to consider is the direction of emerging market currencies versus the US dollar. This relationship closely tracks inflation differentials between the US and EM economies (Chart 23). Chart 23The Link Between EM Currencies And Inflation Chart 24The USD Is The Most Important Factor To Consider   The top panel in Chart 24 emphasizes this point. It shows that EM local-currency sovereign bonds from a USD perspective have returned -2.8% since the peak in EM currencies in early 2013. This coincides with a time when EM currencies, on a real effective exchange rate basis, weakened against the US dollar (Chart 24, bottom panel). Other drivers of local-currency sovereign yields include commodity prices, global trade, and EM sovereign bond yields. However, this year has witnessed a significant decoupling between local bond yields and these drivers (Chart 25). Chart 25Sustainable Divergence? Chart 26Investors Continue To Hunt For Yield In Emerging Markets Our EM strategists wonder whether we are seeing a “new normal” for EM local bond yields – a paradigm in which they fall, not rise, during periods of slowing global growth and behave similarly to DM yields.16  This, however, would imply that investors view EM local debt as a safe haven rather than a risky asset class. We agree with their conclusion that the recent rally in EM local sovereign bonds – hence the decline in yields – was due, rather, to investors’ hunt for yield in an environment of over $10 trillion of negative-yielding debt (Chart 26). This trend is likely to continue in the short term until there is a sustained pickup in global growth. Once that happens, long-term yields are likely to rise in tandem (Chart 27). Chart 27ALong Term Yields Will Rise When Global Growth Picks Up Chart 27BLong Term Yields Will Rise When Global Growth Picks Up Diversification And Portfolio Impact Investors with a broad mandate can think about EMD as part of their overall portfolios. We analyze how the addition of EMD to a monthly rebalanced “conventional” portfolio, consisting of 50% global equities, 30% global treasurys, and 20% global corporate debt (split equally between investment-grade and high-yield bonds), would have performed since 2003. We found that the incremental additions of each of the three segments of EMD – from 5% to 20% each – produced a higher portfolio risk-adjusted return relative to the conventional portfolio. In all cases, replacing global equities, treasurys, and corporate bonds with EM debt, led either to a higher annualized portfolio return, reduced volatility, or sometimes both (Table 4). Unsurprisingly, given the cyclicality of EM assets, the “enhanced” portfolios have a higher correlation with global equities, as well as with DM corporate bonds (Table 5). Table 4Portfolio Simulation: Risk-Return Profiles (Feb. 2003 – Feb. 2020) Table 5EMD Is Highly Correlated With Global Equities And Corporate Bonds It is important to note, however, that most of the outperformance from the enhanced portfolios – particularly in the most heavily EMD-tilted portfolios – occurred before the slowdown in emerging economies beginning in 2013 (Chart 28). Since 2013, as the USD appreciated against EM currencies, allocating to EM local-currency sovereign bonds detracted from portfolio returns. During this period other EM risk assets, such as equities and corporate bonds, also underperformed their DM counterparts. Chart 28Allocating To EMD Adds Some Value Our Current View Over the past few years, GAA has been structurally negative on EM risk assets – both equity and debt. Productivity levels, far below historical averages, have been a key reason for this view (Chart 29). In a previous Special Report, we argued that productivity needs to mean-revert to its historical average for emerging markets to perform well, but that this is unlikely without structural reform. 17 Chart 29Global Productivity Growth Levels Chart 30Divergence Between Spreads And Growth   Tactically, however, there are times when EM assets can outperform despite the structural headwinds (2016-2017 was an example of this). This could happen again later this year, if global growth continues to rebound. Nonetheless, this optimistic view is on hold due to the risk to global growth in the short term from the coronavirus outbreak. Our global strategists expect global growth to fall to zero in the first quarter of 2020, before picking up throughout the rest of the year – assuming the outbreak is contained within the next few weeks.18  Providing this happens, and our view of global growth reaccelerating pans out, EMD should perform well. Within the asset class, segment selection is key. The environment is likely to be more favorable for EM hard-currency sovereign debt than hard-currency corporate debt or local-currency sovereign bonds. The recent divergence between hard-currency sovereign spreads and growth metric could point to an attractive entry point for investors (Chart 30). We remain cautious on EM corporate bonds, which are vulnerable in the face of sluggish domestic demand in most emerging economies, leading to contracting profits (Chart 31). A weaker USD, when global growth recovers, helped by a dovish stance from the Fed, should keep US financial conditions loose and help EM local-currency sovereign debt perform well (Chart 32). However, relative financial conditions between the US and emerging markets are just as important to monitor. If growth in EM economies fails to pick up, EM currencies could depreciate, putting downward pressure on local-currency sovereign bonds.  Chart 31EM Corporates Face Weak Domestic Demand Chart 32Easier US Financial Conditions Lead To Better EM LC Sovereign Returns We will wait to pull the trigger on this recommendation until we get further clarity regarding the impact on growth of the coronavirus outbreak. Conclusion EMD has grown to become an interesting asset class for allocators, allowing them to capitalize on bonds with higher yields than their DM counterparts. Not only has EMD provided higher returns, it gives equity-like exposure to emerging markets with significantly reduced downside during recessions and market selloffs. We recommend clients view EMD as three separate segments – hard-currency sovereign debt, hard-currency corporate debt, and local-currency sovereign debt – due to the different dynamics that influence each segment. Global growth, the direction of EM currencies versus the US dollar, and EM domestic demand are the three most important overall factors to consider when allocating to any of the segments of EMD.   Amr Hanafy, Senior Analyst amrh@bcaresearch.com   Footnotes 1We use the BIS’s definition of international debt securities (IDS) for hard-currency debt, and domestic debt securities (DDS) for local-currency debt. 2Includes both financial and nonfinancial corporations. 3For the purpose of assessing this segment, we use the broad EM and regional Bloomberg Barclays USD Aggregate Sovereign Indices, which track USD-denominated bonds issued by EM governments. Another commonly used index is the J.P. Morgan Chase & Co.’s EMBI Global Diversified Index, which tracks EM hard-currency sovereign debt, as well as fully owned and explicitly guaranteed quasi-issuers. Additionally, J.P. Morgan Chase & Co’s suite of indices following EM Sovereign debt includes their EMBI+ index. This index is primarily focused on EM sovereign issuers, however with a stricter liquidity requirement for inclusion. The reason why we do not rely on this index is due to its tilt towards LATAM and away from Middle Eastern and Asian economies. 4Please see Emerging Markets Strategy Special Report titled, “A Primer On EM External Debt,” available at ems.bcaresearch.com. 5Commercial index providers treat such distinctions by separating quasi-sovereign entities that are/are not fully owned by governments. For example, J.P. Morgan Chase & Co.’s EMBI Global Diversified Index, probably the most widely used index in tracking EM hard-currency sovereign debt, includes sovereign debt as well as fully owned and explicitly guaranteed quasi-issuers in its index. 6Please see “Fears mount over rise of sovereign-backed corporate debt,” Financial Times, dated January 5, 2016. 7Please see “Dubai World secures deal to restructure $14.6bn debt” Financial Times, dated January 12, 2015. 8For the purpose of assessing this segment, we use the broad EM and regional USD Aggregate Corporate Indices, which track USD-denominated bonds issued by EM corporates. 9Includes Basic Industry, Capital Goods, Communication, Consumer Cyclical, Consumer Non-Cyclical, Energy, Technology, and Transportation sectors. 10Please see Global Asset Allocation Special Report, “High-Yield Bonds: Low Volatility Equities?”, available at gaa.bcaresearch.com 11Annualized returns since 2004. 12Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed and Refined,” available at gaa.bcaresearch.com 13Please see “Emerging market corporate default and recovery rates, 1995 – 2018,” Moody’s Investors Service, dated January 30, 2019. 14For the purpose of assessing this segment, we use the J.P Morgan GBI-EM global diversified index, an investable benchmark accessible to most investors. This index tracks local-currency bonds issued by EM governments. 15Please see “JP Morgan to add China bonds to GBI-EM indexes from February 2020,” Reuters, dated September 4, 2019. 16Please see Emerging Markets Strategy Weekly Report titled, “EM Local Bonds: A New Normal?”, available at ems.bcaresearch.com. 17Please see Global Asset Allocation Special Report titled, “Return Assumptions – Refreshed and Refined,” available at gaa.bcaresearch.com. 18Please see Global Investment Strategy Report titled, “Markets Too Complacent About The Coronavirus,” available at gis.bcaresearch.com.    

Highlights Dear Client, This week, we had originally planned to publish a Special Report introducing a framework for modeling and selecting global yield curve trades. In light of the market turbulence of the past few days, however, we felt the need to provide a short note updating our current thoughts on the expanding threats to the global economy and financial markets from the coronavirus (a.k.a. 2019-nCoV, COVID-19). Thus, this week, you will be receiving two reports from BCA Research Global Fixed Income Strategy. Kind regards, Robert Robis Feature The news of more occurrences of the COVID-19 virus in countries outside China – South Korea, Italy, Iran, and Israel – has created a new wave of fear among investors who had started to see signs that the spread of the virus was losing some momentum in China. The appearance of COVID-19 infections in countries like Italy, where there was no obvious connection to the epicenter in China, raised new concerns that the outbreak could turn into a true global pandemic that would be a major negative shock to global growth. The latest market moves fit the profile of a major risk-off move driven by higher uncertainty. Global equities have sold off sharply over the past two trading sessions, and volatility measures like the VIX have spiked. The 10-year US Treasury yield reached a new all-time low (on an intraday basis) of 1.35% yesterday, leaving it -18bps below the 3-month US Treasury bill rate. That curve inversion has occurred alongside falling TIPS breakevens and rising expectations of Fed rate cuts in 2020, in a familiar parallel to the “tariff war shock” of 2019 that prompted the Fed to lower the funds rate by a cumulative 75bps. We see some similarities today to a more recent “black swan” event: the June 2016 UK Brexit vote, which was when the previous intraday all-time low in US Treasury yields was reached. Yield movements have been somewhat smaller in other countries where yields were already very low to begin with, like the 10-year German bund reaching -0.49% and 10-year UK Gilt hitting 0.54% yesterday. Global credit markets have also underperformed, with corporate bond spreads widening alongside spiking equity market volatility in the US and Europe. Amidst the fear, investors have been searching for a potential roadmap to follow, for economies and financial markets, based on past viral outbreaks like the 2003 SARS epidemic and the 2009 global swine flu (H1N1) pandemic. We see some similarities today to a more recent “black swan” event: the June 2016 UK Brexit vote, which was when the previous intraday all-time low for US Treasury yields was reached. After that stunning electoral outcome, investors worldwide tried to process the potential negative implications of an unexpected political outcome. Risk assets sold off and government bonds rallied sharply. Global policymakers responded with various easing measures, both direct (rate cuts and fresh QE from the Bank of England) and indirect (delayed Fed rate hikes, more QE from the ECB). This all came at a time when global growth momentum was already picking up before the Brexit vote, stoked by large-scale fiscal and monetary stimulus in China (Chart 1). In the end, the supportive monetary/fiscal backdrop, and not the political uncertainty, won out and the global economy – along with risk assets and bond yields – all recovered over the second half of 2016. Chart 1Doomsday? Or 2016 Revisited? Today, policymakers are starting to mobilize to fight the threat to growth from COVID-19, hinting at potential monetary easing measures. China is already set to deliver more monetary and fiscal easing, although it is not clear if those will be on the same massive scale as 2015/16. While the scale of the shock to global growth from a potential pandemic is obviously far different than the political uncertainty of Brexit, stimulus measures in 2020 could generate a similar positive response from financial markets if the coronavirus impacts growth less than currently feared. So what should investors expect next? We admit that we do not have a strong conviction level on near-term market moves, given how the coronavirus outbreak has set off an unpredictable chain of events that has gone against our base case expectation of a global growth rebound in 2020. Yet amidst all the uncertainty and fear, we can hazard a few guesses as to the potential future moves in global bond markets. For riskier borrowers, the ability to service debt is what matters most, and the majority of borrowers can still meet their interest payments with global borrowing costs near all-time lows. DURATION: A lot of bad news is discounted in current global bond yield levels, both in terms of absolute levels and expected rate cuts. Yet until there are signs of the virus being contained, both within and outside China, investors will continue to seek out hedges for the uncertainty. That means the any challenge to the current downward momentum in yields may not become evident until the economic data releases begin to show signs of a Q2 recovery from what is assuredly going to be an awful Q1 for the global economy. YIELD CURVE: A continuation of the risk-off momentum in global equity markets will put additional bull-flattening pressure on developed market government bond yield curves in the near term. The more medium-term move, however, should be towards steeper yield curves. Either the viral outbreak becomes contained and/or the growth shock is minimized, triggering a reversal of the latest risk-off bull flattening into risk-on bear-steepening; or the economic downturn and risk asset selloff intensifies and central banks deliver rate cuts that will bull-steepen global yield curves. CREDIT: Global corporate bond spreads should remain under upward pressure in the near term until the spread of the coronavirus outbreak begins to ease. However, the cumulative spread widening in credit markets could turn out to be surprisingly modest. The conditions that are typically in place before credit bear markets and periods of sustained spread widening – tight monetary policy and rapidly deteriorating corporate financial health – are not currently in place. This is true in both the US and Europe for high-yield, where our bottom-up Corporate Health Monitors are still sending a neutral message – thanks largely to interest coverage ratios that are still above typical pre-recessionary levels (Chart 2). For riskier borrowers, the ability to service debt is what matters most, and the majority of borrowers can still meet their interest payments with global borrowing costs near all-time lows - even in the event of a sharp, but short, global economic slowdown. Chart 2Low Yields Supporting High-Yield Borrowers   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com  

Highlights In case you missed it in real-time, please listen to a playback of this this quarter’s webcast ‘What Are The Most Attractive Investments In Europe?’ available at eis.bcaresearch.com. Growth is set to plunge in the first quarter, keeping bond yields depressed for the early part of 2020 at least. Stay structurally overweight equities versus bonds so long as bond yields stay around current or lower levels. A 10 basis points decline in the 10-year bond yield can offset a 2 percent decline in stock market profits. Underweight economically sensitive sectors – and regional and country equity indexes with a high weighting to them – until growth and bond yields enter a convincing uptrend. A strong signal for shifting to a more pro-cyclical stance in the coming months would be if/when the 10-year bond yield has reached a sufficiently strong 6-month deceleration. Fractal trade: the strong outperformance of utilities versus oil and gas is technically stretched. Feature Chart I-1Forget Growth, It's All About Valuation ‘Global health scare takes world stock markets to new highs’ would make a jarring, provocative, and counterintuitive headline. But it would be true… at least so far. Most economists expect the global health scare emanating from China to depress economic growth. My colleague, Peter Berezin, forecasts global growth to drop to near zero during the first quarter. Yet the aggregate stock market seems largely unfazed. Most bourses are riding high, and in some cases not far from all-time highs. How can this be if the market is downgrading growth? Ultra-Low Bond Yields Are Protecting The Stock Market Although stock market profits are being revised down, the multiple paid for those profits is rising by more than the profits are falling. Stock market valuations have become hyper-sensitive (inversely) to ultra-low bond yields. Meaning that the valuation boost from a small decline in bond yields is more than sufficient to counter the growth drag from the coronavirus scare. This is not just a recent phenomenon. For the past two years, a good motto for investors has been: forget growth, it’s all about valuation (Chart of the Week). Through 2018-19, profits drifted sideways. Yet the stock market fell 30 percent, then rose 30 percent – because the multiple paid for the profits plunged in 2018, then surged in 2019 (Chart I-2 and Chart I-3). The reason was the dramatic swing in bond yields. This is hardly surprising given that the prospective return on equities is sensitive to the prospective return offered by competing (long-duration) bonds. But crucially, at ultra-low bond yields, this sensitivity becomes hyper-sensitivity. Chart I-2The Big Moves In The Stock Market... Chart I-3...Have Been About Valuation, Not Growth When bond yields approach their lower bound, bonds become extremely risky investments because the scope for price rises diminishes while the scope for price collapses increases. The upshot is that all (long-duration) investments become equally risky, and the much higher prospective returns required on formerly more risky equities collapses to the feeble return offered on now equally-risky bonds. Given that valuation is just the inverse of the prospective return, the valuation of equities becomes hyper-sensitive to small changes in bond yields. A 10 basis points decline in the bond yield can offset a 2 percent decline in stock market profits Through 2018-2019, the 10-year T-bond yield took a round trip from around 2 percent to 3.2 percent and then down to around 1.6 percent today. This explains the mirror-image round trip in the stock market’s multiple: from 16 down to 13 and then up to around 17 today, a 30 percent increase. Which means that broadly speaking, a 10 basis points decline in the bond yield can offset a 2 percent decline in stock market profits (Chart I-4). Chart I-4The Bond Yield Is Driving The Stock Market's Valuation Therefore, as the coronavirus scare illustrates, the biggest structural threat to the aggregate stock market does not come from slowing growth so long as bond yields continue to adjust downwards. The biggest threat comes from an outsized increase in bond yields, stemming from a subsequent modest acceleration in either growth or inflation. But we do not expect this in the first half of the year (at least). Bond Yields To Stay Depressed For The First Half At Least Although the coronavirus scare is a convenient scapegoat for the growth downgrade, the scare has just amplified a growth deceleration that was going to happen anyway. As we explained at the start of the year in Strong Headwind Warrants Caution In H1, a growth deceleration in Europe and worldwide during early 2020 was already well baked in the cake. The 6-month acceleration in bond yields at the end of 2019 was among the sharpest in recent years. Growth decelerations stem neither from the level of bond yields nor from the change in bond yields (or financial conditions). Growth decelerations stem from the acceleration of bond yields. And the 6-month acceleration in bond yields at the end of 2019 – both in Europe and worldwide – was among the sharpest in recent years (Chart I-5). Chart I-5After A Sharp 6-Month Acceleration In Bond Yields, Yields Stay Depressed For The Following 6 Months Although the link between a bond yield acceleration and a GDP deceleration seems hard to grasp, it results from a basic accounting identify. GDP is a flow statistic. So if a credit flow contributes to GDP, it must be a credit flow deceleration that contributes to a GDP deceleration. And if the level of the bond yield establishes the size of a credit flow, it must be a bond yield acceleration that establishes the size of a credit flow deceleration (Chart I-6).  Chart I-6A Bond Yield Acceleration Causes A Credit Flow Deceleration Given the lags between bond yields impacting credit flows and credit flows impacting spending, a sharp 6-month acceleration in the bond yield – like the one experienced at the end of 2019 – tends to keep the bond yield depressed for the following six months. On this basis, we would not expect an outsized increase in the bond yield during the first half of this year. In fact, a continued decline in yields could eventually turn into a sharp 6-month deceleration in the bond yield, leading to an acceleration in credit flows and growth, and providing a forthcoming opportunity to become more pro-cyclical.  Big Winners And Losers Across Sectors, Regions, And Countries To repeat, the growth scare has not had a major impact on the aggregate stock market (so far) because the valuation boost from a small decline in bond yields is more than sufficient to counter the downgrade to profits. But the growth scare has had a major impact on sector, regional, and country winners and losers. Understandably, the sectors most exposed to the declining bond yield have performed very well. These fall under two categories: the first is bond proxies, meaning sectors that pay a stable bond-like income, such as utilities; the second is long-duration investments meaning sectors whose income is likely to grow rapidly, such as tech and healthcare. This is because the more distant is the future cash flow, the greater is the uplift to its ‘net present value’ for a given decline in the bond yield. The growth scare has had a major impact on sector, regional, and country winners and losers. Conversely, the sectors most exposed to short-term growth have performed poorly. These include banks and energy. Banks suffer also because declining bond yields erode their net interest (profit) margin (Chart I-7). In turn, the sector winners and losers have determined the regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. When energy underperforms, the energy-heavy Norway and UK stock markets must underperform. It also follows that the tech-heavy and healthcare-heavy US stock market must outperform (Chart I-8).  Chart I-7Sector Winners And ##br##Losers... Chart I-8...Explain Regional And Country Winners And Losers Some of the more extreme sector and country outperformances and underperformances are now technically stretched (see following section). Nevertheless, a general strategy to underweight economically sensitive sectors – and regional and country equity indexes with a high weighting to them – will remain appropriate until growth and bond yields enter a convincing uptrend. To reiterate, one strong signal for shifting to a more pro-cyclical stance in the coming months would be if/when the bond yield has reached a sufficiently strong 6-month deceleration. Stay tuned. Fractal Trading System* The strong outperformance of utilities versus oil and gas is technically stretched, especially in the US, and a reversal is likely within the next three months. Short US utilities versus oil and gas, setting a profit target of 7.5 percent with a symmetrical stop-loss. In other trades, short Ireland versus Europe reached the end of its holding period having achieved half of its profit target. The rolling 1-year win ratio now stands at 59 percent. Chart I-9US: Utilities Vs. Oil And Gas When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The elevated uncertainty about global growth stemming from the COVID-19 virus in China has not only made investors more anxious, but central bankers as well. This means that, only six weeks into the year, policymakers may already be having to rethink their expected strategies for 2020 - which were, for the most part, sitting on hold after the monetary easing in 2019. This has important implications for the direction of global bond yields, which were starting to see a cyclical increase before the viral outbreak. In this report, we present what we see as the most important data for investors to focus on in the major developed markets to get the central bank call correct. This is based on our interpretation of recent speeches, press conferences and published research. We also provide our own suggested data series to watch for each country – which do not always line up with what central bankers are saying they are most worried about. We conclude that it is still not clear that the global growth backdrop has turned sustainably more bond bullish, but there is no pressure on any of the major central banks to move away from extremely accommodative policy settings. Feature Over the past four weeks, all of the major central banks have had the opportunity to formally communicate their current views to financial markets. Whether it was through post-policy- meeting press conferences or published monetary policy reports, central bankers have tried to signal their intentions about future changes in the direction of interest rates, given the heightened uncertainties about the momentum of global growth. At the moment, our global leading economic indicator (LEI) is still signaling that 2020 should see some rebound in global growth – and bond yields – after the sharp 2019 manufacturing-led slowdown (Chart 1). Unfortunately, the latest read on the global LEI uses data as of December, so it does not include what is almost certainly to be a very severe slowdown in the Chinese (and global) economy in the first quarter of 2020 due to the COVID-19 virus outbreak. Underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year.  Central bankers are in the same spot as investors, trying to ascertain the extent of the hit to global growth from the virus, both in terms of size and, more importantly, duration. This comes at a time when many central banks were already formally rethinking how to meet their own individual inflation-targeting mandates given the persistence of low global inflation alongside tight labor markets (Chart 2). Chart 1Global Bond Yields: Think Globally, Act Locally Chart 2Common Worries For All CBs: China & Global Inflation That all sounds potentially very bond-bullish, but a lot of bad economic news is already discounted in the current low level of global bond yields. More importantly, the underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year. In this Weekly Report, we provide a brief synopsis of what we believe are the biggest concerns for each of the major developed economy central banks. This is based on our read of recent policy decisions and central banker statements, as well as our own understanding of the current reaction function of policymakers. Our intention is to provide a short list of indicators to watch for each central bank, to help cut through the noise of data and news during this current period of unusual uncertainty, as well as our own assessment of what policymakers should be focusing on more. We conclude that it is still too soon to expect a new wave of bond-bullish global monetary policy easings in 2020. It will take evidence pointing to an extended shock to global growth from the COVID-19 virus to reverse the bond-bearish signal from other indicators like our global LEI. Federal Reserve Chart 3Federal Reserve: Focus On Financial Conditions & Inflation Expectations Currently, the Fed’s commentary suggests a policy bias that can be described as “neutral-to-dovish”, but it is giving no indication that additional rate cuts are likely in 2020 after the 75bps of cuts last year. Markets remain skeptical, however, with -42bps of cuts over the next twelve months now priced into the USD overnight index swap (OIS) curve according to our Fed Discounter (Chart 3). What the Fed seems most focused on: Fed officials seem focused on measures of market-based inflation expectations, like TIPS breakevens, as the best indication that current policy settings are appropriate (or not) relative to the growth outlook of investors. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019 (middle panel). Right now, with the 10-year TIPS breakeven at 1.67% and the 10-year/3-month US Treasury curve now at only -1bp, another decline in longer-term inflation expectations will likely invert the Treasury curve. What the Fed should be more focused on: US financial conditions are highly stimulative, with equity indices back near all-time highs and corporate credit spreads remaining well-contained at tight levels. Given the usual lead times of financial conditions indices to US cyclical growth indicators like the ISM manufacturing index (bottom panel), a continuation of the most recent bounce in the ISM is still the most likely result – even allowing for a near-term hit to global growth from China. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019. Bottom Line: The incoming US growth data is critical to determine the Fed’s next move. If there is no follow through from easy financial conditions into faster growth momentum, the odds increase that the Treasury curve will become more deeply inverted for a longer period of time – an outcome that would likely prompt more rate cuts, especially if equity and credit markets also begin to sell off as growth disappoints. European Central Bank Chart 4ECB: Focus On Manufacturing & Inflation Expectations The ECB has been clearly signaling that it still has a dovish bias, although central bank officials have acknowledged that the options available to them to ease further are limited with policy rates already in negative territory. The market agrees, as there are only -7bps of cuts over the next twelve months now priced into the EUR OIS curve according to our ECB Discounter (Chart 4). What the ECB seems most focused on: The ECB has been paying the most attention to the contractions in euro area manufacturing data (like PMIs) and exports seen in 2019. Rightly so, as nearly all of the two percentage point decline in year-over-year euro area real GDP growth since the late-2017 peak has come from weaker net exports. The central bank has also been concerned about the depressed level of inflation expectations, with the 5-year EUR CPI swap rate, 5-years forward, now at only 1.23% - far below the ECB’s inflation target of “at or just below” 2%. What the ECB should be more focused on: We agree that the focus for the ECB should be most concerned about the weakness in manufacturing/exports and low inflation expectations – the latter having not yet responded to extremely stimulative euro area financial conditions (most notably, the weak euro). The euro area economy is highly leveraged to Chinese demand, with exports to China representing 11% of total euro area exports. This makes leading indicators of Chinese economic activity, like the OECD China LEI and the China credit impulse, critically important indicators in determining the future path of European export demand. The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. Bottom Line: The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. If the China demand shock to euro area exports is large enough, the ECB will likely be forced to deliver a modest interest rate cut – or an expansion of the size of its monthly asset purchases – to try and boost growth. Bank Of England Chart 5Bank Of England: Focus On Business Sentiment & Labor Costs The Bank of England (BoE) has a well-deserved reputation as having an unpredictable policy bias under outgoing Governor Mark Carney, but the central bank does appear to be currently leaning on the moderately dovish side of neutral. Short-term interest rate markets also feel the same way, with -19ps of easing over the next twelve months priced into the GBP OIS curve according to our BoE Discounter (Chart 5). What the BoE seems most focused on: The BoE has been paying a lot of attention to indicators of UK business sentiment, which had been negatively impacted by both Brexit uncertainty and global trade tensions in 2019. The BoE has focused on the link from depressed business sentiment to weak investment spending and anemic productivity growth as an important reason why UK potential GDP growth has been so low and why UK inflation expectations have been relatively high. What the BoE should be more focused on: We agree that business sentiment should be the BoE’s greatest area of focus. Sentiment has shown a solid improvement of late, after the signing of the “phase one” US-China trade deal in December and the formal exit of the UK from the EU on January 31. The CBI Business Optimism survey (measuring the net balance of optimists versus pessimists) soared from -44 in October to +23 in January – the biggest quarterly jump ever recorded in the series. It remains to be seen if this improvement in confidence can be sustained and begin to arrest the steady decline in UK capital spending and productivity growth, and the associated surge in unit labor costs and inflation expectations, that has taken place since the 2016 Brexit vote. Bottom Line: The BoE’s next move, under the new leadership of incoming Governor Andrew Bailey, is not clear. Inflation expectations remain elevated but the recovery in business sentiment is still fragile. One potential risk to watch: UK Prime Minister Boris Johnson may choose to take a bolder stand on trade negotiations with the EU after his resounding election victory in December, risking an outcome closer to the “no-deal Brexit” scenario that was most feared by UK businesses. Bank Of Japan Chart 6Bank of Japan: Focus On Exports & The Yen The Bank of Japan (BoJ) seems to have had a perpetually dovish bias since the 1990s. Yet the current group of policymakers under Governor Haruhiko Kuroda, realizing that they have run out of realistic policy options after years of extreme stimulus, has not been signaling that fresh easing measures are on the horizon, even with economic growth and inflation remaining very weak in Japan. Markets have taken the hint, with only -6bps of rate cuts over the next twelve months priced into the JPY OIS curve according to our BoJ Discounter (Chart 6). What the BoJ seems most focused on: The BoJ has been vocally concerned about the recent slump in Japanese consumer spending, which declined -2.9% (in real terms) in Q4 after the sales tax hike last October. That blow to consumption was expected, but could not have come at a worse time for a central bank that was already worried about plunging Japanese manufacturing activity and exports – the latter declining by -8% in nominal terms as of December 2019. There is little hope for a near-term rebound given the certain hit to global growth and export demand from virus-stricken China. What the BoJ should be more focused on: Given that Japan is still an economy with a large manufacturing sector that is levered to global growth, the BoJ should remain focused on the path for Japanese exports. A bigger risk, however, comes from the Japanese yen, which has remained very stable over the past year. It has proven very difficult to generate any rise in Japanese inflation without some yen weakness, and with headline CPI inflation now only at +0.2%, a burst of yen strength would likely tip Japan back into outright deflation. Bottom Line: The BoJ is now stuck in a very bad spot, with no real ability to provide a major monetary policy stimulus for the stagnant Japanese economy. At best, all the central bank could do is deliver a small interest rate cut and hope for a quick rebound in global manufacturing activity and/or some yen weakness to boost flagging inflation. Bank Of Canada Chart 7Bank of Canada: Focus On Housing & Capital Spending The Bank of Canada (BoC) surprised many observers by keeping policy on hold last year, even as central banks worldwide engaged in various forms of monetary easing to offset the effects of the global manufacturing downturn. The BoC’s recent messaging has been relatively neutral, in our view, although Governor Stephen Poloz has not completely dismissed the possibility of rate cuts in his speeches. The markets are strongly convinced that the BoC will need to belatedly join the global easing party, with -32bps of rate cuts now priced into the CAD OIS curve according to our BoC Discounter (Chart 7) What the BoC seems most focused on: The BoC remains highly concerned over the high level of Canadian household debt, especially given how Canadian consumer spending has been highly geared towards trends in house price inflation over the past few years. This is likely why the BoC has been reluctant to cut policy rates as “insurance” against the effects of a prolonged global growth slump, to avoid stoking a new Canadian housing bubble. Interestingly, the commentary from BoC officials has taken on a bit more dovish tone whenever USD/CAD has threatened to break down below 1.30, suggesting some fears of unwanted currency appreciation. What the BoC should be more focused: The BoC should continue to monitor developments in the Canadian housing market, given the implications for consumer spending and, potentially, financial stability if there is another boom in house prices. The central bank should also pay even greater attention than usual to the subdued level of oil prices, which has triggered a deep slump in the oil-rich Alberta province that has weighed on the overall level of Canadian business investment spending. Persistently soft oil prices would also force the BoC to continue resisting strength in the Canadian dollar. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Bottom Line: The BoC appears under no pressure to make any near-term interest rate adjustments, especially with realized inflation now sitting at the midpoint of the BoC’s 1-3% target band. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Reserve Bank Of Australia Chart 8Reserve Bank Of Australia: Focus On Underemployment & Housing The Reserve Bank of Australia (RBA) has been very transparent over the past year, loudly signaling a dovish bias and following through with 75bps of rate cuts that took the Cash Rate to a record low of 0.75%. The latest messaging has been a bit more balanced, while still leaving the door to additional rate cuts if the economy worsens. Markets are expecting at least one more easing, with -24bps of rate cuts over the next twelve months priced into the AUD OIS curve, according to our RBA Discounter (Chart 8). What the RBA seems most focused on: The RBA’s main concerns have centered around the persistent undershoot of Australian inflation, with core inflation remaining below the central bank’s 2-3% target band since the beginning of 2016. The central bank has attributed this to persistent excess capacity in the Australian labor market, as evidenced by the elevated underemployment rate. The RBA is also paying close attention to the Australian housing market and its links to consumer spending, with house prices already responding positively to last year’s RBA rate cuts. The outlook for exports is also on the RBA radar, particularly after the recent surge that lifted the Australia trade balance into surplus but is now at risk from a plunge in Chinese demand. What the RBA should be more focused on: We agree that the labor market should be the main focus for the RBA, particularly the underemployment rate which is still high at 8.3%, signaling that core CPI inflation should remain subdued (bottom panel). We also see the RBA as potentially being more sanguine about the risks of a renewed upturn in the housing market than many observers expect, since that would provide a potential offset to a likely pullback in exports which are now a record 25% of GDP (middle panel). Bottom Line: The RBA still has a clear dovish bias, even though they are currently on hold to assess the impact of last year’s easing. RBA Governor Philip Lowe noted in a recent speech that more cuts may be necessary “if the unemployment rate deteriorates”, suggesting that the labor market is the main area of focus for the central bank. Reserve Bank Of New Zealand Chart 9Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation The Reserve Bank of New Zealand (RBNZ) was one of the more dovish central banks in 2019, cutting the Cash Rate by 75bps to a record low of 1%. The overall tone of the central bank’s recent commentary remains cautious, but has taken on a more balanced tone. Markets are priced appropriately, with only -13bps of rate cuts over the next twelve months discounted in the NZD OIS curve according to our RBNZ Discounter (Chart 9). What the RBNZ seems most focused on: The latest messaging from the RBNZ has highlighted the downside risks to New Zealand from weak global growth, but those are now more manageable since the central bank estimates the economy is operating at full employment. In its latest Monetary Policy Statement (MPS), the RBNZ noted that the economy has been able to weather the weakness in global growth thanks to the positive terms of trade effect from elevated New Zealand export prices – a trend that the central bank expects will persist in 2020 even if external demand remains sluggish (middle panel). The central bank has also expressed some concern over the recent pickup in domestically-driven inflation measures, with core CPI inflation back above 2% (bottom panel). What the RBNZ should be more focused on: The RBNZ is right to focus on global growth, particularly given the coming demand shock from virus-stricken China. While the New Zealand dollar has always been a critical variable for the RBNZ in its policy decisions, the currency now takes on added importance given the central bank’s expectation that export prices and the terms of trade will remain elevated. If the latter turns out to be wrong, the RBNZ will be far more likely to take actions to ensure that the Kiwi dollar stays undervalued. Bottom Line: The RBNZ still has a dovish policy bias, but the hurdle to deliver additional rate cuts after last year’s easing seems a bit higher now. It would likely take a major downturn in global growth, combined with a decline in New Zealand export prices and some cooling of domestic inflation, to get the RBNZ to cut again in 2020. Investment Conclusions Based on our “whirlwind tour” of the major developed market central banks in this report, we can make the following conclusions regarding the expected path of interest rates, and bond yields, in these countries: There are no central banks with anything resembling a hawkish bias – not surprising in the current slow global growth environment with heightened uncertainty. The least dovish central banks are the BoC and the RBNZ, which are not signaling any urgency to cut rates. The most dovish central bank is the RBA, which is indicating a clear willingness to cut again if domestic growth deteriorates. The Fed and the BoE are somewhere in the middle of the “dovishness” spectrum, with both likely willing to ease policy but only under a specific set of circumstances. The ECB and BoJ are clearly boxed in having policy rates already below the zero bound, limiting their ability to ease further if needed. In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months.  Looking back at our Central Bank Discounters, the largest amount of rate cuts over the next year are now discounted in the US (-42bps), Canada (-32bps), Australia (-24bps) and the UK (-19bps). At the same time, the fewest cuts are priced in Japan (-6bps), the euro area (-7bps) and New Zealand (-13bps). In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months. The odds seem more “fair” in the other countries, in terms of the size of rate cut expectations versus the probability of those cuts actually being delivered because of domestic economic considerations. What does this all mean for global bond investing this year? For that we can turn to our Global Golden Rule framework, which links expected returns of government bonds versus cash to the difference between actual and expected rate cuts.1 US Treasuries and Canadian government bond yields are most at risk of underperforming their global peers in 2020 as the Fed and BoC disappoint the current dovish rate cut expectations discounted in interest rate markets.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns