Monetary

We are strongly committed to our 2 percent inflation objective and to achieving it on a sustained and symmetric basis. – Jerome Powell, May 1, 2019 St Louis Fed President James Bullard, a voting member of the central bank’s policy committee, said he “certainly would be open to a cut” should inflation continue to fall short of expectations after the summer. – Financial Times, May 3, 2019 The Federal Reserve’s preferred measure of prices (the core personal consumption deflator) rose by 1.6% in the year to March, a shortfall from the 2% inflation target. Moreover, the 10-year-moving average of core inflation has remained persistently below the 2% level over the past 17 years (Chart 1). Recent comments from some policymakers and market analysts highlight growing concerns about this shortfall. Personally, I see little to worry about. Chart 1Core Inflation: Not Quite At 2% Core Inflation: Not Quite At 2% Core Inflation: Not Quite At 2% For investors, high and rising inflation is a terrible thing, as is its even more evil twin, a high and accelerating pace of deflation. The Holy Grail for investors and policymakers alike is for actual inflation and inflation expectations to remain both low and stable. It seems to me that this has been achieved, with resulting huge benefits to the economy and financial markets. It matters little that inflation has fallen slightly short of the arbitrary 2% target. If inflation was problematically low, what might we expect to see? Importantly, companies would be complaining about a tough pricing environment and pressure on profits. Yet, S&P 500 profit margins are close to an all-time high (Chart 2). And that is providing powerful support to the stock market, with the S&P 500 also close to its highs. If there were building deflationary pressures in the economy, then it also would be reasonable to expect spreading signs of economic distress. While not every indicator is flashing green, the overall economy is doing just fine. Healthy employment growth, rising real wages and strong profits are more consistent with a nascent inflation problem than with deflation. According to the National Federation of Independent Business survey, small companies’ main problem is the quality of labor, not concerns about demand. Excessively low inflation is a problem for debtors, but loan delinquency rates – albeit a lagging indicator – are well contained. The Fed makes a big deal about the importance of keeping inflation expectations anchored – i.e. stable at a low level. There does not appear to be any major problem on this front. For example, the New York Fed’s survey of consumers shows median expected inflation of 2.9% in three years’ time (Chart 3). The University of Michigan Survey of Consumers shows expected inflation of 2.3% over the next 5-10 years. The gap between nominal and real 10-year Treasury yields – a proxy for financial market inflation expectations – is lower (currently 1.88%), but that measure moves around a lot and is highly correlated with oil prices. No measures of expected inflation are in free-fall or dangerously low. Chart 2No Signs Of Pricing Distress No Signs of Pricing Distress No Signs of Pricing Distress Chart 3Inflation Expectations Are Contained Inflation Expectations Are Contained Inflation Expectations Are Contained   What If? Suppose that the Fed had been prescient enough to realize 10 years ago that, despite its best efforts, core inflation would average only 1.6% rather than the desired 2% over the coming decade. Presumably, the Fed would have taken even more extreme actions than actually occurred, implying a bigger expansion of its balance sheet. It is unclear whether it would have been any more successful in pushing up actual inflation. But we can be sure that it would have further inflated asset prices and encouraged even more leverage in the corporate sector. Increased financial imbalances in the economy – asset price overshoots and greater leverage – would not have been an attractive trade-off to pushing up inflation by an average 40 basis points. The core problem is that monetary policy is ill-equipped to deal with the forces that have held back economic growth. A combination of demographics, high debt and slower productivity growth have limited the U.S. economy’s potential. Thus, I have a lot of sympathy for Larry Summer’s secular stagnation thesis. Yes, that implies that the real equilibrium interest rate is very low and, therefore, that monetary policy needs to be accommodative. But it also implies that force-feeding the system with easy money is more likely to lead to asset bubbles and financial distortions than to increased consumer price inflation. What About Policy Ammo For The Next Downturn? One of the main arguments for getting inflation up is to give the Fed more scope to ease policy in the next recession. In the past, the Fed has cut the funds rate by an average of around 500 basis points during recessions. Going into the next downturn with inflation and thus interest rates close to current levels means it would not take long for the funds rate reach the constraints of the zero bound. However, this also would be the case if core inflation was at or modestly above the 2% target. That is why some commentators (e.g. Olivier Blanchard and Larry Summers) have argued for an inflation target of 4% during good times in order to allow for a large fall in interest rates when times turn bad. As long as inflation is in moderate single digits, its stability probably is more important than its level. In other words, if inflation was at 4% and was expected by all economic and financial agents to remain at that level for the foreseeable future, then the economy should not perform any worse than if inflation had stabilized at 2% - and it might even perform better. However, central banks have long had the view that the higher the inflation rate, the less stable it would be. And the same logic would apply to the downside if there was deflation. For example, once inflation rises from 2% to 4%, then it could easily move from 4% to 6% etc. Given the challenges of fine-tuning monetary policy, that view has merit. Raising the inflation target is all very well, but if central banks are having trouble getting the rate to 2%, how on earth would they get it to 4%. And the same point applies if the Fed were to shift from targeting the inflation rate to targeting the level of prices or of nominal GDP. If boosting the Fed’s balance sheet from less than $1 trillion to $4.5 trillion did not get inflation to 2%, what would it take to get inflation to 4%? It is always possible to increase inflation. For example, the government could give all households a check for $10,000 that had to be spent on domestically-produced goods and services. Furthermore, assume the checks were valid only for one year and the fiscal costs were directly financed by the Fed. This would undoubtedly unleash a powerful consumer boom and a spike in inflation. And the government could keep repeating the exercise until a sustained inflation upturn took hold. But that is an unrealistic scenario except in the event of an Armageddon economic situation. And it hardly would fit in with keeping inflation stable at a modestly higher pace. A recession is very likely within the next couple of years and monetary policy will indeed face major constraints on its actions. We undoubtedly would see renewed quantitative easing on a heroic scale with an expanded range of assets purchased by the central bank. And advocates of Modern Monetary Theory may well have their wishes granted with direct monetary financing of fiscal deficits. But, as already noted, policymakers would face these policy challenges regardless of whether inflation was modestly below or above the 2% target. Be Careful What You Wish For The Fed spent three decades squeezing inflation out of the system. In the 1970s and 1980s, high inflation expectations were deeply embedded in the behavior of consumers, companies and investors. It was a long and at times painful process to change that psychology. With inflation expectations now in the range of 2% to 3%, the Fed can claim success. Why would they want to risk undoing that achievement? Letting the economy run hot to try and offset sub-2% inflation with a period of above-2% inflation would be a dangerous strategy. History shows us that central banks have both limited understanding of the inflation process and limited control over the economy. If policymakers were successful in raising inflation, they run the risk that expectations would no longer be anchored. Moreover, the Fed would have a massive problem in communicating the logic of a pro-inflation strategy. Having spent so long in selling the message that low and stable inflation is the best way to maximize long-run economic growth, it likely would create considerable confusion to then say that a period of higher inflation was acceptable. Investors and businesses would face huge uncertainty about the magnitude and duration of an inflation overshoot and about whether the Fed could even control the process. The Fed’s credibility undoubtedly would suffer. It is true that policymakers know how to bring inflation back under control – they simply have to tighten policy. But that introduces increased instability into the economy and financial markets. Rather than be obsessed about hitting the 2% target, policymakers should be happy that they have met the requirements of the Federal Reserve Act: “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Policy Outlook And Market Implications The Fed was right to stop raising interest rates. The economy does not appear to be on the verge of overheating and there are enough risks to the outlook to warrant a cautious wait-and-see approach to policy. Yet, I am somewhat troubled by the dovish tone of some Fed officials. Thank goodness President Trump’s recent choices for Fed Board positions are now out of the picture. If I am worried now, I can only imagine how much worse I would have felt with Stephen Moore and Herman Cain on the Board. With no recession on the horizon and the labor markets extremely tight, I fully expect to see inflation gather steam later this year. But I suspect that the Fed will be slow to react. And then the timing of the 2020 elections will become a factor. The FOMC is not particularly sensitive to political considerations, but this is no ordinary President. The Fed would have to be very sure of itself before it started raising rates again in the midst of the election cycle. The bottom line is that we are setting up for a monetary policy error with the Fed falling behind the inflation curve later this year or in early 2020. This will be positive for risk assets in the short run, but poses a big threat down the road. Notwithstanding our concerns about the near-term market impact of current U.S.-China trade tensions, our strategy is thus to remain overweight equities and corporate credit until we see signs that financial conditions are about to significantly tighten.   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com

Highlights U.S.: The Fed remains decidedly neutral, despite market expectations (and White House pressure) for lower U.S. interest rates. Treasury yields are mispriced and should grind higher over the next 6-12 months, led first by inflation expectations and later by a more hawkish Fed. Canada: The Bank of Canada’s latest reports and commentary indicate that monetary policy will stay on hold over at least the balance of 2019. Bond markets are already priced for that outcome. Maintain a neutral stance on Canadian government bonds in global hedged fixed income portfolios. Sweden: The Riksbank’s recent dovish turn, calling for a flatter trajectory for interest rates and extending asset purchases, will keep Swedish bond yields lower for longer. Thus, we are closing our recommended tactical trades in Sweden that were positioned for rate hikes. Feature Global bond yields remain stuck in a range, seeking a new directional narrative. The downside is limited by green shoots of improving global growth (mostly from China stimulus), some commodity price reflation through higher oil prices and robust returns in most risk asset markets (i.e. an easing of financial conditions). At the same time, the upside for yields is capped by dovish forward guidance from data-dependent central banks who see below-trend economic growth and below-target inflation in the rearview mirror. Chart of the WeekForward MIS-guidance Forward MIS-guidance Forward MIS-guidance We expect these opposing forces to be resolved through faster global growth and higher realized inflation over the next 6-12 months. Major central banks will not need to turn even more dovish and begin a monetary policy easing cycle to boost growth, despite current market pricing suggesting otherwise. Global bond yields will grind upward, first through higher inflation expectations and, later, from a shift away from discounting rate cuts and, in some countries, pricing in rate hikes. The pressure for higher yields will be strongest in the U.S., where the Treasury market now discounts that the current 2.5% fed funds rate will be the cyclical peak, below the median FOMC projection, even as inflation expectations have been moving higher (Chart of the Week).  We continue to recommend pro-growth, pro-risk allocations in global fixed income markets: below-benchmark overall duration exposure, favoring global corporates over government bonds, focusing government bond exposure to countries where policymakers will be relatively less hawkish (Japan, U.K., Australia, Canada, New Zealand), and positioning for faster inflation expectations and bearish steepening of yield curves (most notably in the U.S. and core Europe). May FOMC Meeting: Sorry, Mr. President The Fed kept rates unchanged at last week’s FOMC meeting, dashing market hopes of a potential shift in language toward a future rate cut. The official statement acknowledged that U.S. inflation was running below the 2% target, but Fed Chair Jerome Powell later described that inflation shortfall as “transitory” and expected to reverse. Treasury yields got whipsawed by the mixed messaging, with the 2-year yield falling -6bps after the statement but then climbing +11bps during Powell’s press conference. Powell standing his ground so firmly was a sharp rebuke to U.S. money markets, which remain priced for rate cuts over the next year. It was also a strong sign of the Fed maintaining its political independence in the face of U.S. President Trump calling for aggressive rate cuts. From a growth perspective, the Fed is right to not panic. The employment backdrop remains solid, with the U.S. unemployment rate hitting a 50-year low in April of 3.6%. While cyclical growth indicators like the ISM Manufacturing index have trended lower, the headline index remains above the expansionary 50 level (Chart 2). The rally in U.S. equity and credit markets seen so far in 2019 has eased financial conditions, signaling an imminent rebound in the U.S. leading economic indicator (second panel). Furthermore, core measures of retail sales and capital goods orders have begun to reaccelerate after the Q1 slump impacted by the U.S. government shutdown. From a growth perspective, the Fed is right to not panic. On the inflation side, the story is more nuanced. Higher oil prices will boost headline inflation measures over the next six months. At the same time, the lagged impact of the surprising pickup in U.S. productivity growth (+2.4% year-over-year in Q1) will help dampen core inflation rates (Chart 3) via lower unit labor costs (flat year-over-year in Q1). Further complicating the issue for the Fed is the impact of lower inflation in the components that Fed Chair Powell deemed “transitory”, such as airfares, apparel and, most interestingly, the cost of financial services. Chart 2A Blossoming U.S. ##br##Rebound A Blossoming U.S. Rebound A Blossoming U.S. Rebound Chart 3Blame Equities For The Cooling Of ##br##U.S. Core Inflation Blame Equities For The Cooling Of U.S. Core Inflation Blame Equities For The Cooling Of U.S. Core Inflation The broad Financial Services and Inflation grouping, which includes market-related costs such as wealth management fees, now represents 9% of the overall U.S. core PCE deflator. The inflation rate of the Financial Services index is highly correlated to the performance of U.S. equity markets (Chart 4). This makes sense, as the costs of professional portfolio management are often tied to the size of assets under management. At a minimum, the market should be priced for the same neutral (unchanged) stance that the Fed is currently signaling, which is appropriate given signs of U.S. growth perking up. Chart 4Faster Productivity Means The Fed Can Be Patient Faster Productivity Means The Fed Can Be Patient Faster Productivity Means The Fed Can Be Patient In 2018, prior to the year-end correction in U.S. equity markets, the contribution to core PCE inflation from the Financial Services category was a steady 0.5-0.6 percentage points. After the market rout, that contribution has fallen to 0.2 percentage points, accounting for nearly all of the 40bp decline in core PCE inflation since U.S. equities peaked last September. With equity markets having now regained all the late-2018 losses, Financial Services inflation should boost core PCE inflation by at least 20-30bps by year-end – and perhaps more if stocks continue to appreciate, per the BCA House View. With our Fed Monitor now sitting just above the zero line, indicating no pressure on the Fed to hike rates, the -30bps of rate cuts now discounted over the next year is too aggressive (Chart 5). At a minimum, the market should be priced for the same neutral (unchanged) stance that the Fed is currently signaling, which is appropriate given signs of U.S. growth perking up. The Fed will remain cautious on returning to a more hawkish stance until actual U.S. inflation turns higher, which will take some time given the competing forces of falling unit labor costs and fading “transitory” disinflationary effects. Chart 5Stay Underweight USTs & Below-Benchmark UST Duration Stay Underweight USTs & Below-Benchmark UST Duration Stay Underweight USTs & Below-Benchmark UST Duration We think the 2017 experience will be useful to think about in the coming months. Then, the Fed paused its rate hiking cycle for a few months, primarily due to softer inflation readings related to unusual forces temporarily dampening core inflation (most notably, a one-time collapse in wireless phone prices related to a change in how those costs were measured). Once those “transitory” forces faded out of the data, the Fed resumed lifting the funds rate. It will likely take longer in 2019 before the Fed would feel confident enough to begin raising rates again, especially with the funds rate now much closer to neutral than two years ago. Nonetheless, we expect a similar story of rebounding inflation driving Treasury yields higher to unfold over the latter half of this year. A moderate below-benchmark U.S. duration stance, favoring shorter maturities, combined with a long position in inflation-protected TIPS over nominal Treasuries, remains appropriate. Bottom Line: The Fed remains decidedly neutral, despite market expectations (and White House pressure) for lower U.S. interest rates. Treasury yields are mispriced and should grind higher over the next 6-12 months, led first by inflation expectations and later by a more hawkish Fed. Canada Update: Stay Neutral Back in March, we upgraded our recommended Canadian government bond exposure to neutral after spending a long time at underweight.1 The rationale for our move was that the stunning loss of momentum in the Canadian economy at the end of 2018 would force the Bank of Canada (BoC) to not only stop raising rates, but stay on hold for longer than expected. After our upgrade, we noted that we would consider additional changes to our Canadian allocation after the releases of the latest BoC Business Outlook Survey (BoS) and the updated economic projections at the April 24 monetary policy meeting. None of those events makes us want to move away from the current neutral recommendation. The problem for the BoC is that its policy rate of 1.75% remains well below its own estimated neutral range, which is now 2.25%-3.25% (Chart 6). A similar message comes when looking at the neutral real rate (“r-star”) estimate for Canada produced by the New York Fed, with an r-star of 1.5% versus a current real policy rate around 0%.2 This suggests that Canadian monetary policy remains accommodative and that the BoC should be looking for opportunities to continue moving interest rates toward “neutral” when the economy is accelerating. Yet our own BoC Monitor suggests that an unchanged policy stance is currently appropriate, while -11bps of rate cuts are now discounted in the Canadian Overnight Index Swap (OIS) curve. In other words, the BoC is torn between a fundamental interest rate framework that says the hiking cycle is not done yet, and a sluggish economy that demands a dovish bias. The BoC is torn between a fundamental interest rate framework that says the hiking cycle is not done yet, and a sluggish economy that demands a dovish bias. In the press conference following the April 24 BoC policy meeting, BoC Governor Steve Poloz noted that any reference to the need for interest rates to return to the BoC’s neutral range was deliberately omitted from the official policy statement. This is a clear signal that the central bank has shifted its focus from “normalizing” rates to preventing a deeper downturn in Canadian growth. The latest BoS showed that business confidence, expected sales and future investment intentions all fell sharply in the first quarter of 2019 (Chart 7). There was a huge drop in the number of firms reporting capacity pressures and labor shortages, with more firms now expecting their prices to fall than rise over the next year. The main headwinds to the diminished outlook for future sales were related to “a more uncertain outlook in the Western Canadian energy sector, continued weakness in housing-related activity in some regions, and tangible impacts from global trade tensions”.3 Chart 6A Long Way From BoC ##br##Rate Cuts A Long Way From BoC Rate Cuts A Long Way From BoC Rate Cuts Chart 7Negative Messages From The BoC Business Outlook Survey Negative Messages From The BoC Business Outlook Survey Negative Messages From The BoC Business Outlook Survey   The BoC places a lot of weight on the BoS in determining its economic forecasts, and in setting monetary policy. Thus, it is no surprise that in the official statement following the April 24 monetary policy meeting, the BoC Governing Council noted that they were “monitoring developments in household spending, oil markets and global trade policy to gauge the extent to which the factors weighing on growth and the inflation outlook were dissipating”.4 Those were the same three concerns of businesses highlighted in the BoS, assuming that “weakness in the Canadian housing market” is related to “developments in household spending” – a logical link given the high level of Canadian household and mortgage debt. Looking at those three factors, there is nothing suggesting that the BoC needs to adjust policy anytime soon (Chart 8). Oil prices are rising, but household spending remains weak and global trade uncertainties have not completely diminished and Canadian export growth has stagnated. Given the mixed picture from the economic data, the BoC will likely remain on hold until there is a clear signal from the data. From a bond investment strategy perspective, staying at neutral also makes sense. A move to overweight Canadian bonds would require an even deeper economic downturn into recessionary territory that would push Canadian unemployment higher (Chart 9). Downgrading back to underweight, however, would require signs of a sustainable rebound in Canadian domestic demand and stronger global growth that would boost Canadian exports – an outcome that would not be visible in the data until at least the third quarter of 2019. Chart 8Watch What The BoC ##br##Is Watching Watch What The BoC Is Watching Watch What The BoC Is Watching Chart 9A Neutral Weight On Canada Is Still Justified A Neutral Weight On Canada Is Still Justified A Neutral Weight On Canada Is Still Justified   One final point on staying neutral on Canada comes from looking at cross-country spread levels between government bonds in Canada and other major developed economies. The spread levels look historically wide versus sovereign debt from Germany, the U.K., and Australia; wide versus recent history in Japan; but very narrow versus the U.S. (Chart 9). Those spreads are shown without hedging out the currency risk of going long Canadian bonds – and, by association, the Canadian dollar. Once the currency risk is hedged out of those cross-country spreads using 3-month currency forwards, the spread differentials are all far less interesting both in absolute terms and relative to history (Chart 10 & 11). Chart 10Big Differences In Canadian Bond Spreads Vs Other Major DM... Big Differences In Canadian Bond Spreads Vs Other Major DM... Big Differences In Canadian Bond Spreads Vs Other Major DM... Chart 11… But Those Spreads Disappear Once The C$ Exposure Is Hedged ...But Those Spreads Disappear Once The C$ Exposure Is Hedged ...But Those Spreads Disappear Once The C$ Exposure Is Hedged So even on an individual country basis, there is no compelling case to be anything but neutral Canadian government bonds versus global currency-hedged benchmarks – which is how we present all our fixed income recommendations in Global Fixed Income Strategy. Bottom Line: The Bank of Canada’s latest reports and commentary indicate that monetary policy will stay on hold over at least the balance of 2019. Bond markets are already priced for that outcome. Maintain a neutral stance on Canadian government bonds in global hedged fixed income portfolios. Sweden Trade Update – Time To Retreat & Regroup Exactly one year ago (May 8, 2018), we initiated trades in our Tactical Overlay portfolio to position for tighter monetary policy, and higher bond yields, in Sweden.5 Specifically, we have been recommending shorting 2-year Swedish government bonds versus German equivalents (hedging the currency exposure back into krona), while also selling 2-year Swedish bonds and buying 10-year Swedish debt in a yield curve flattening trade. The positions were chosen to benefit from an expected bearish repricing of the short-end of the Swedish curve. At this time last year, the positive upward momentum of Swedish growth and inflation had reached a point where the Riksbank was clearly – and credibly – signaling that the long process of normalizing its highly accommodative crisis-era monetary policies would begin. That meant lifting policy rates away from negative territory, as well as shutting down the bond-buying quantitative easing (QE) program. One year later, the economic backdrop has done a 180-degree turn against our original thesis (Chart 12): Swedish growth has slowed, with both the manufacturing PMI and leading economic indicator at the lowest levels since 2013. Unemployment has increased and nominal wage growth has rolled over. Headline CPIF inflation has fallen back below the Riksbank 2% target, while core CPIF inflation remains stuck near 1.5%. The Riksbank changed its forward guidance at last month’s monetary policy meeting, signaling that the benchmark interest rate will remain at -0.25% for “somewhat longer” than was indicated as recently as February (when a rate hike around the end of 2019 or in early 2020 was signaled). The Riksbank also pledged to maintain the size of its QE bond purchases from July 2019 to December 2020, a dovish surprise. Swedish money markets are still discounting 13bps of rate hikes over the next twelve months. Yet our Riksbank Monitor, on the other hand, is now indicating a need for rate cuts, driven by both softer inflation and weaker growth. The minutes from last month’s policy meeting revealed that the forward guidance was adjusted simply because headline inflation had temporarily dipped back below the 2% Riksbank target. The implication is that a return to 2% inflation would prompt the Riksbank to hike. Swedish money markets are still discounting 13bps of rate hikes over the next twelve months. Yet our Riksbank Monitor, on the other hand, is now indicating a need for rate cuts, driven by both softer inflation and weaker growth. A useful rule for investment risk management is: when the underlying rationale for a position is clearly not unfolding as expected, the best thing to do is simply close that position and look for new opportunities better aligned to the current reality. Chart 12No More Pressure On Riksbank ##br##To Hike No More Pressure On Riksbank To Hike No More Pressure On Riksbank To Hike Chart 13Time To Exit Our Recommended "Hawkish" Trades In Sweden Time To Exit Our Recommended "Hawkish" Trades In Sweden Time To Exit Our Recommended "Hawkish" Trades In Sweden With that in mind, we are choosing to close our tactical trades in Sweden (Chart 13). The 2-year Sweden-Germany spread trade generated a loss of -52bps (including the return from hedging the euro exposure in Germany back into Swedish krona). We were more fortunate with the curve flattening trade, which generated a return of +61bps as the Swedish curve bullishly flattened through falling 10-year yields rather than bearishly flattening through rising 2-year yields (our original expectation). Thus, we are closing out our Sweden trades at a small net gain of +9bps. We will do a deeper analysis on Sweden in an upcoming Global Fixed Income Strategy report to search for new potential trade ideas. Bottom Line: The Riksbank’s recent dovish turn, calling for a flatter trajectory for interest rates and extending asset purchases, will keep Swedish bond yields lower for longer. Thus, we are closing our recommended tactical trades in Sweden that were positioned for a faster path of rate hikes.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “March Calmness”, dated March 19, 2019, available at gfis.bcaresearch.com. 2 The NY Fed’s estimates for non-U.S. r-star rates for the euro area, Canada, and the U.K. can be found on the NY Fed website. https://www.newyorkfed.org/research/policy/rstar 3https://www.bankofcanada.ca/2019/04/business-outlook-survey-spring-2019/ 4https://www.bankofcanada.ca/2019/04/fad-press-release-2019-04-24/ 5 Please see BCA Global Fixed Income Strategy Special Report, “Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore”, dated May 8, 2018, available at gfis.bcaresearch.com. Recommendations Reconcilable Differences Reconcilable Differences Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

The Fed that has adopted an abruptly dovish stance and a recently inverted 10-year/fed funds rate yield curve indicates the market’s expectation that the next Fed move will be a cut, corroborated by elevated probabilities of a cut by December. This has driven a marked increase in client requests on positioning if rates are falling. Accordingly, we have updated our research to answer the question: what sectors perform best when the Fed eases? The results of our analysis of the seven Fed loosening cycles since 1965 are presented in the table below. The sector results are telling: defensives lead the pack in advance of a rate cut as market participants smell trouble and a defensive rotation occurs. The key source of funds in this defensive rotation in advance of a loosening cycle is S&P tech which underperforms early and continues to underperform dramatically through the initial stages of the loosening cycle. While we are not forecasting a cut and BCA’s view remains one of no recession for the coming 12 months, the production of this report may well be early. Nevertheless, its use as a sector positioning/return road map is evergreen; please see Monday’s Special Report for more details. Chart 1 ​​​​​​​

Highlights Chart 1Is Low Inflation Transitory? Is Low Inflation Transitory? Is Low Inflation Transitory? Persistent /pə’sıst(ə)nt/ adj. If inflation runs persistently above or below 2 percent, then the Fed would be forced to adjust its policy stance to nudge it back towards target. Transitory /’trænsıtərı/ adj. If inflation’s deviation from target is only transitory, it means that it will return to target even if the Fed maintains its current policy stance. Symmetrical /sı‘metrık(ə)l/ adj. The Fed’s inflation target is symmetrical because the FOMC is as concerned with undershoots as it is with overshoots. More recently, some members are urging the Fed to demonstrate the target’s symmetry by explicitly pursuing an overshoot.  Last week, Chair Powell described recent low inflation readings as transitory (Chart 1). In other words, the Fed believes that interest rates are already low enough to send inflation higher over time. Equally, with downbeat inflation expectations signaling doubts about the symmetry of the Fed’s target (bottom panel), the committee is in no rush to hike. The result is status quo monetary policy for the time being. With the market priced for 25 basis points of rate cuts over the next 12 months, investors should keep portfolio duration low. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 95 basis points in April, bringing year-to-date excess returns up to +365 bps. The corporate bond sector’s strong outperformance has resulted in spread tightening across the credit spectrum. In fact, average index spreads for the Aaa, Aa and A credit tiers are now at or below our fair value targets.1 Only the Baa credit tier, which accounts for about 50% of index market cap, remains attractively valued, with an average spread 11 bps above target (Chart 2). We recommend that investors focus their investment grade credit exposure on Baa-rated bonds. The combination of above-trend economic growth and accommodative Fed policy creates a favorable environment for credit risk. Spreads should continue to tighten in the near-term. However, we will turn more cautious once Baa spreads reach our target. Gross corporate leverage ticked higher in Q4, breaking a year-long downtrend (panel 4). Meantime, while C&I lending standards eased slightly in Q1 after having tightened in Q4 (bottom panel), C&I loan demand contracted for the third consecutive quarter. Weaker loan demand in the Fed’s Senior Loan Officer Survey often precedes tighter lending standards, and tighter lending standards usually coincide with wider corporate bond spreads.    Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 137 basis points in April, bringing year-to-date excess returns up to +710 bps. Junk spreads for all credit tiers remain above our spread targets (Chart 3).2 At present: The Ba-rated option-adjusted spread is 214 bps, 35 bps above target. The B-rated spread is 356 bps, 79 bps above target. The Caa-rated spread is 709 bps, 145 bps above target. An alternative valuation measure, the excess spread available in the junk index after accounting for expected default losses, is currently 267 bps, slightly above average historical levels (panel 4). However, this measure uses the Moody’s baseline default rate forecast of 1.7% for the next 12 months. For that forecast to be realized, it would require a substantial decline from the current default rate of 2.4%. In a previous Special Report, we flagged some reasons why the Moody’s forecast might be too optimistic.3 Among them is the increase in job cut announcements, which remains a concern despite last month’s drop (bottom panel). If we assume that the default rate holds at 2.4% for the next 12 months, the default-adjusted junk spread would fall to 237 bps. Still reasonably attractive by historical standards, and consistent with positive excess returns. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in April, dragging year-to-date excess returns down to +27 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, as a 5 bps widening in the option-adjusted spread (OAS) was partially offset by a 4 bps drop in the compensation for prepayment risk (option cost). At 42 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains below the pre-crisis mean (Chart 4). In fact, we would assign high odds to MBS outperformance during the next few months. Not only is the OAS attractive, but mortgage refinancings – which have recently caused the nominal MBS spread to widen – have probably peaked (panel 2). Following its sharp decline earlier in the year, the 30-year mortgage rate has now leveled-off. Another downleg is unlikely, given the recent improvements in housing data. New home sales and mortgage purchase applications have both surged in recent months, while homebuilder optimism remains close to one standard deviation above its long-run mean.4 Moreover, even at current mortgage rates we calculate that only about 17% of the conventional 30-year MBS index is refinanceable.  All in all, given that corporate credit offers higher expected returns, we continue to recommend only a neutral allocation to MBS. However, MBS spreads are very likely to tighten during the next few months.   Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 37 basis points in April, bringing year-to-date excess returns up to +152 bps. Sovereign debt outperformed duration-equivalent Treasuries by 83 bps on the month, bringing year-to-date excess returns up to +420 bps. Local Authorities outperformed the Treasury benchmark by 67 bps and Foreign Agencies outperformed by 40 bps, bringing year-to-date excess returns up to +208 bps and +192 bps, respectively. Domestic Agencies outperformed by 10 bps in April, bringing year-to-date excess returns up to +29 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +23 bps. The Fed’s on-hold policy stance and signs of improvement in leading global growth indicators could set the U.S. dollar up for a period of weakness. All else equal, a softer dollar makes USD-denominated sovereign debt easier to service, benefiting spreads. However, a period of dollar weakness driven by improving global growth would also benefit U.S. corporate bonds, and valuation is heavily tilted in favor of U.S. corporate debt relative to sovereigns (Chart 5). Given that the last period of significant sovereign outperformance versus corporates was preceded by much more attractive valuation (panels 2 & 3), we maintain an underweight allocation to sovereign debt for the time being. We make an exception for Mexican sovereign debt, where spreads are attractive compared to similarly rated U.S. corporates (bottom panel). Our Emerging Markets Strategy service also thinks that the market is taking too dim a view of Mexican government finances.5 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 52 basis points in April, bringing year-to-date excess returns up to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 3% in April, and currently sits at 78% (Chart 6). This is more than one standard deviation below its post-crisis mean and slightly below the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) outperformed short-dated munis (2-year and 5-year) dramatically last month, but yield ratios at the long end remain well above those at the short end of the curve (panel 2). In other words, the best value in the municipal bond space continues to be found at the long-end of the Aaa muni curve. We showed in a recent report that lower-rated and shorter-maturity munis are much less attractive.6 First quarter GDP data revealed that state & local government tax revenues snapped back sharply in Q1, following a contraction in 2018 Q4. Meanwhile, current expenditures actually ticked down. Incorporating an assumption for Q1 corporate tax revenues, we forecast that state & local government interest coverage jumped to 16% in Q1 from 4% in 2018 Q4.7  This is consistent with municipal ratings upgrades continuing to outpace downgrades for the time being (bottom panel). Treasury Curve: Adopt A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in April. The 2/10 Treasury slope steepened 10 bps on the month and currently sits at 21 bps (Chart 7). The 5/30 slope steepened 7 bps on the month and currently sits at 60 bps. In recent reports we have urged investors to adopt barbell positions along the yield curve. In particular, investors should avoid the 5-year and 7-year maturities and instead focus their allocations at the very short and long ends of the curve.8 There are three main reasons to prefer a barbell positioning. First, the 5-year and 7-year yields are most sensitive to changes in our 12-month discounter. In other words, those yields fall the most when the market prices in rate cuts and rise the most when it prices in rate hikes. With recession likely to be avoided this year, the market will eventually price rate hikes back into the curve. Second, barbells currently offer a yield pick-up relative to bullets. The duration-matched 2/10 barbell offers 8 bps more yield than the 5-year bullet (panel 4), and the duration-matched 2/30 barbell offers 5 bps more yield than the 7-year bullet. This means that investors will earn positive carry in barbell positions while they wait for rate hikes to get priced back in. Finally, almost all barbell combinations look cheap according to our yield curve fair value models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 81 basis points in April, bringing year-to-date excess returns up to +157 bps. The 10-year TIPS breakeven inflation rate rose 13 bps on the month and currently sits at 1.91% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.02%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. As we noted in a recent report, the Fed has clearly pivoted to a more dovish stance in an effort to re-anchor inflation expectations at levels more consistent with its 2% target.9 This change should support wider TIPS breakevens, though investors will also need to see evidence of firming realized inflation before meaningful upside materializes. So far, such evidence is in short supply. Year-over-year core PCE inflation dipped to 1.55% in March. However, as Fed Chair Powell went out of his way to mention in last week’s press conference, core PCE was dragged down by one-off adjustments in the ‘Clothing & Footwear’ and ‘Financial Services’ components. In fact, 12-month trimmed mean PCE inflation actually moved up in March. It now sits at 1.96%, just below the Fed’s target (bottom panel). The combination of a dovish Fed and above-trend economic growth should push TIPS breakevens higher over time. Maintain an overweight allocation to TIPS versus nominal Treasuries. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in April, bringing year-to-date excess returns up to +49 bps. The index option-adjusted spread for Aaa-rated ABS narrowed one basis point on the month and, at 32 bps, it remains close to its all-time low (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 40 basis points in April, bringing year-to-date excess returns up to +187 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level but somewhat higher than levels seen last year (Chart 10). In a recent report, we noted that non-agency CMBS offer the best risk/reward trade-off of any Aaa-rated U.S. spread product.10 While we remain cautious on the macro outlook for commercial real estate, noting that prices are decelerating (panel 3) and banks are tightening lending standards (panel 4) amidst falling demand (bottom panel), we view elevated CMBS spreads as providing reasonable compensation for this risk for the time being. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in April, bringing year-to-date excess returns up to +95 bps. The index option-adjusted spread tightened 2 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive 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 U.S. 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. At present, the market is priced for 25 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record 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. Image Image Appendix B - Butterfly Strategy Valuation 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: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. 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 April 30, 2019) The Fed's Inflation Dictionary The Fed's Inflation Dictionary 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 April 30, 2019) The Fed's Inflation Dictionary The Fed's Inflation Dictionary 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 +56 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 56 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) The Fed's Inflation Dictionary The Fed's Inflation Dictionary 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 U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A High Bar For Rate Cuts”, dated April 30, 2019, available at usbs.bcaresearch.com 5 Please see Emerging Markets Strategy Special Report, “Mexico: The Best Value In EM Fixed Income”, dated April 23, 2019, available at ems.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 7 Corporate tax revenue is not released until the second GDP estimate. We assume that the 2019 Q1 value equals the 2018 Q4 value. 8 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Feature Leading indicators of inflation, and hence a hawkish Fed, remain biased to the upside. The S&P 500 is close to all-time highs, the U.S. dollar has been strong this year, and wage growth has been resilient. Almost exactly eight years ago, we published a report examining historical sector performance across the various Fed tightening cycles.1 We now find ourselves on the other side with a Fed that has adopted an abruptly dovish stance and a recently inverted 10-year/fed funds rate yield curve indicating the market’s expectation that the next Fed move will be a cut. Accordingly, we have updated our research to analyze the opposite perspective when rates are falling and answer the question: what sectors perform best when the Fed eases? Such an exercise may seem ill-timed; leading indicators of inflation, and hence a hawkish Fed, remain biased to the upside. The S&P 500 is close to all-time highs, the U.S. dollar has been strong this year, and wage growth has been resilient (Chart 1). Nevertheless, we have been inundated by client requests on this topic and, while we may well be early in its production, its use as a sector positioning/return road map is evergreen and not necessarily to forecast that a Fed cut is nearing. Chart 1Inflation Indicators Still Don’t Point To A Cut Inflation Indicators Still Don’t Point To A Cut Inflation Indicators Still Don’t Point To A Cut The results of our analysis of the seven Fed loosening cycles since 1965 are presented in Table 1. While we highlight the May 1980 iteration as an easing cycle, we have excluded it from our analysis owing to its returns overlap with the March 1981 iteration less than a year later, which offers a cleaner analysis. Table 1Sector Relative Performance And Seven Fed Easing Cycles Sector Performance And Fed Loosening Cycles: A Historical Roadmap Sector Performance And Fed Loosening Cycles: A Historical Roadmap Still, the sector results are telling: defensives lead the pack in advance of a rate cut as market participants smell trouble and a defensive rotation occurs. Some of the results should be taken with a grain of salt. As shown in Table 1, the broad market delivers significant returns 24 months after an easing cycle begins. However, the last two easing cycles (January 2001 and September 2007) witnessed the S&P returning -37% and -31%, respectively, two years post rate cut. Thus, a rate cut does not signal with certainty a positive two year return. The key source of funds in this defensive rotation in advance of a loosening cycle is S&P tech which underperforms early and continues to underperform dramatically through the initial stages of the loosening cycle. Still, the sector results are telling: defensives lead the pack in advance of a rate cut as market participants smell trouble and a defensive rotation occurs (Chart 2). However, the results are not unambiguous as the rate-sensitive defensive S&P utilities and S&P telecoms indexes both underperform early while S&P consumer staples and S&P health care are the top performers of all sectors prior to, and both one and two years post rate cut (Charts 4 & 5). Chart 2 Chart 3 The key source of funds in this defensive rotation in advance of a loosening cycle is S&P tech which underperforms early and continues to underperform dramatically through the initial stages of the loosening cycle (Chart 3). This is an excellent and consistent leading signal that we are monitoring closely. S&P tech’s deep cyclical peer S&P industrials surprisingly does not show advance warning of a loosening cycle, though persistently underperform once the cycle is underway. Also surprising is S&P energy’s outperformance in the early stages of a lower rate environment. Chart 4 Chart 5 The current implied fed funds probabilities are roughly 50-50 for a rate cut at the Fed’s December 2019 meeting and move increasingly towards a rate cut thereafter. While we are not forecasting a cut and BCA’s view remains one of no recession for the coming 12 months, were a Fed cut to materialize, our barbell portfolio approach will likely be able to absorb the Fed shock. We highlight our overweight recommendation on S&P consumer staples and S&P energy along with our neutral recommendation on S&P health care as sector winners in an easing cycle and our underweight recommendation for S&P consumer discretionary as a sector laggard as rates fall. We further note our neutral recommendation on S&P tech. The reference charts below show individual sector relative performance charts along with the fed funds rate (shaded areas depict the initial Fed rate cut).   Chris Bowes, Associate Editor U.S. Equity Strategy ChrisB@bcaresearch.com Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Chart 6 CHART 6 CHART 6 Chart 7 CHART 7 CHART 7 Chart 8 CHART 8 CHART 8 Chart 9 CHART 9 CHART 9 Chart 10 CHART 10 CHART 10 Chart 11 CHART 11 CHART 11 Chart 12 CHART 12 CHART 12 Chart 13 CHART 13 CHART 13 Chart 14 CHART 14 CHART 14 Chart 15 CHART 15 CHART 15   Footnotes 1      Please see BCA U.S. Equity Strategy Special Report, “Sector Performance And Fed Tightening Cycles: An Historical Roadmap” dated April 25, 2011, available at uses.bcaresearch.com.

Highlights The business cycle has been extended, … : The expansion is nearly a year older than it was last summer, but the next recession could well be further away now than we estimated it was back then. … thanks to the Fed’s pause, … : Recessions only occur when monetary conditions are tight. The longer the Fed pauses its rate-hiking campaign, the longer the expansion will persist. … and the upshot is that the shelf life of our recommendations has been extended: Corporate earnings don’t meaningfully contract outside of recessions, so equities don’t typically enter bear markets, and bond defaults don’t typically spike, while the economy is expanding. Stay the course until monetary policy is on the way to turning restrictive: The Fed’s pause is risk-asset-friendly, and investors should continue to prioritize the return on their capital. Focusing on return of capital can wait until monetary policy turns hawkish. Feature Late last July, we began outlining our positions on the key macro drivers of financial markets: rates, credit, the business cycle, and the state of monetary policy. Laying out our big-picture views, and the rationale underpinning them, provides us with a framework for evaluating incoming data and adjusting asset-allocation strategy as necessary. Nine months on, our macro views are very nearly unchanged, and we expect they will remain so for the rest of the year. That would have come as a surprise to us last summer, when we anticipated that 2019 might finally bring the macro inflection points that would dictate de-risking portfolios to preserve capital ahead of the next bear market. The Fed’s pause has been the key to extending the shelf life of our views. We continue to expect that the transition from accommodative to restrictive monetary policy will be the catalyst for the inflection points that investors most care about: the end of the expansion, the end of the equity bull market, and the point at which spread product ceases to generate positive excess returns over Treasuries. By abandoning the gradual normalization pace it maintained throughout 2017 and 2018, the Fed has postponed its crossing of the neutral-rate Rubicon. That postponement has indefinitely extended the expansion, and the credit and equity bull markets in turn. There is no free lunch, however. Unless low rates for even longer shift the economy’s potential long-run growth rate higher, they will only pull future investment gains forward into the present. In other words, we expect the Fed’s pause will allow risk assets to reach higher cyclical peaks than they otherwise would at the cost of suffering larger declines once restrictive monetary policy settings are ultimately imposed. Barring an exogenous shock that causes a recession or some sort of financial-market scare, we expect robust investment returns, possibly crowned by an incremental melt-up in equities. The longer the Fed delays removing monetary accommodation, the longer the expansion, and the equity bull market, will continue. Our base case, then, is to stay the course with risk-friendly positioning, maintaining at least an equal weight in equities and spread product. We are expending much of our research energy on weighing the challenges to our constructive view. We are particularly focused on signs that the nine rate hikes the Fed has already executed might be slowing the economy, that the economy is at risk of overheating, or that investor euphoria constrains future returns. This week’s report considers the current backdrop on all three counts. Has The Fed Already Squeezed The Economy? At first blush, the first quarter’s real 3.2% growth would seem to do in the notion that the Fed has already reined in the economy. Alas, there was much less to the GDP release than meets the eye, as it was goosed by a 100-basis-point (“bps”) contribution from net exports and a 65-bps contribution from inventory restocking (Chart 1). Real final domestic demand grew by only 1.5%. Measured against 2018’s 3% growth in real final domestic demand, and 2.5% and 2.4% in 2017 and 2016, respectively, the first quarter represented a noticeable slowdown. Given the 40-bps decline in fiscal thrust from 2018 to 2019 (Chart 2), some growth deceleration is inevitable this year. Thanks to a projected 40 bps of fiscal stimulus, we expect that growth will still exceed the economy’s long-run approximate 2% potential growth rate. We are undeterred by the first quarter’s underlying weakness, though, because the economy is not likely to face such daunting challenges again this year. The first quarter began on the heels of a sudden 19% peak-to-trough decline in the S&P 500 that shaved nearly $4 trillion from household wealth; a similar blowout in credit spreads spooked would-be home buyers and must have made some business borrowers table their investment plans. Chart 1Much Less Than Meets The Eye Much Less Than Meets The Eye Much Less Than Meets The Eye Chart 2Fiscal Policy Is Still Easy Fiscal Policy Is Still Easy Fiscal Policy Is Still Easy The quarter also began in the midst of the 35-day federal government shutdown that lasted nearly all of January. Furloughed government employees would eventually receive back pay for the days they were involuntarily idle, but many had no choice but to curtail spending until they did, causing ripple effects in communities with high concentrations of federal employees. The White House Council of Economic Advisers estimated that the shutdown trimmed 10 basis points a week from GDP. We presented the high-level outlook for GDP growth a month ago, with particular emphasis on the consumption outlook.1 Our constructive consumption view is a function of the surging labor market’s impact on household incomes and the post-crisis shoring up of household balance sheets. Consumer confidence has declined from its cyclical peak, but it remains elevated relative to history, and the expectations component has historically marched in lockstep with consumption (Chart 3). The two series have diverged over the last few years, perhaps because of a desire to shore up balance sheets, but consumer confidence remains elevated, and is positioned to support spending in much the same way as bulked-up household balance sheets (Chart 4). Chart 3Ample Confidence Leaves Plenty Of Room For More Spending Ample Confidence Leaves Plenty Of Room For More Spending Ample Confidence Leaves Plenty Of Room For More Spending Solid consumption should bolster nonresidential investment, and survey data suggest that it is not about to roll over in any event (Chart 5). Residential investment has exerted a modest drag on GDP for seven of the last eight quarters, but homes remain quite affordable relative to history, and we still see the single-family housing market as undersupplied. Our GDP outlook showed that the state and local component of government spending should be well supported by growing household incomes, and ventured that it’s hard to see how federal spending will slip in a presidential election year. Last week’s preliminary bipartisan discussions about a $2 trillion infrastructure-spending plan would seem to ensure that it won’t. Chart 4Consumption Fundamentals Are Solid ... Consumption Fundamentals Are Solid ... Consumption Fundamentals Are Solid ... Chart 5... Which Bodes Well For Capex ... Which Bodes Well For Capex ... Which Bodes Well For Capex Are There Signs That The Economy Could Overheat? With its pause, the Fed has indicated that it sees little near-term risk of economic overheating. The available data support that conclusion. Even after a steady multi-year recovery, cyclical spending as a share of GDP is only around its long-run average level (Chart 6, top panel). The three components of cyclical spending that are prone to harmful inventory overhangs – consumer durables (Chart 6, second panel), commercial real estate (Chart 6, fourth panel), and residential real estate (Chart 6, bottom panel) – are all at fairly low levels relative to history. Only equipment and intellectual property is elevated (Chart 6, third panel), but the bulk of its growth is attributable to investment in software and R&D, neither of which carries the same fraught inventory implications as the tangible-good components. One silver lining of the tepid expansion is that it hasn’t ever revved up the engine enough to overheat. Chart 6Cyclical Spending Is Well Below Past Peaks Cyclical Spending Is Well Below Past Peaks Cyclical Spending Is Well Below Past Peaks Chart 7Inventories Are Elevated ... Inventories Are Elevated ... Inventories Are Elevated ... The wholesale inventory-to-sales ratio is elevated (Chart 7), and registers as a yellow light. The labor market is running hot, and we believe it will eventually force the Fed to resume tightening policy, but probably not in any meaningful way until 2020. Injecting a substantial amount of stimulus into an economy already operating at capacity is a textbook recipe for inflation, but inflation is a lagging indicator and the steep decline in oil prices has held back headline price measures. The bottom line is that the aggregate macro data do not suggest that the U.S. economy is in any immediate danger of overheating. Are Investors Too Optimistic? Investor sentiment is properly viewed as a contrarian indicator. When investors are depressed, equity multiples are low and forward earnings expectations are restrained. When they’re euphoric, equity multiples are high and forward earnings expectations are ambitious. The multiple/expectations interaction makes for juicy prospective returns when sentiment is washed out, and stingy prospective returns when sentiment is ebullient. Chart 8... But Sentiment Is Not ... But Sentiment Is Not ... But Sentiment Is Not Barron’s semi-annual Big Money poll of money managers, published in its April 29th edition, suggests that sentiment is nowhere near either extreme, though its respondents are less constructive on equities and the economy than we are. Fewer than half of money managers are bullish on equities over the next twelve months for the first time since 2016, and more of their clients are bearish than bullish. The bullish managers’ expectations were modest; they saw the S&P 500 gaining just over 4% by year-end, and another 3% in the first half of 2020.2 The Barron’s data aligns with other sentiment surveys: individual investor bullishness is below its historical mean (Chart 8, second panel), while advisor optimism is about a standard deviation above its average (Chart 8, third panel), and trader sentiment is slightly bullish (Chart 8, bottom panel). Recession fears continue to dog the markets. Economic slowdown or recession was the most common concern (28%), followed by earnings disappointments (21%) and Fed missteps (13%), meaning that almost two-thirds of investors are concerned about the business cycle and the possibility that the Fed might short-circuit it. One-half of respondents expect a recession to arrive by the end of next year. Their sector calls didn’t reflect a strong cyclicals/defensives bias, though they are avoiding bond proxies like REITs and Utilities, and the majority of respondents expect the 10-year Treasury to yield 3% or more a year from now. Investment Implications The U.S. economy is faring well, but continued above-trend growth is not assured. First quarter GDP was inflated by a one-off boost from net exports and inventory restocking that is not likely to be repeated. A robust labor market should support consumption, but wholesale inventories are high, and retail sales have been making large swings from month to month. We believe that Chinese policymakers have tabled their deleveraging campaign, helping the Chinese economy to rebound and pull the rest of the world along with it, but it is too early to say for certain that ex-U.S. growth has turned around. The uncertain global growth outlook provides stocks with a wall of worry, and the Fed is poised to help them climb it. The upshot is that conditions remain somewhat uncertain. That augurs well for equities and other risk assets because it will allow them to climb a wall of worry. Meanwhile, our base case scenario is that the economy will move forward at a Goldilocks pace. The neither-too-hot-nor-too-cold economy will allow the Fed to continue to be patient and refrain from hiking rates for most, if not all, of the rest of the year. While the Fed stays on hold, risk assets should find the going pretty smooth. We expect that the pause will have the effect of extending the expansion, along with the bull markets in equity and credit. We continue to believe that the Fed’s patience now will beget more aggressive tightening later. Since that tightening will bite after stocks have run up to higher levels than they would otherwise have reached, and spreads are tighter than they would otherwise have gotten, the offsetting bear-market declines will be worse. The ensuing declines are concerns for late 2020 or early 2021, however, and it is too early for investors to prepare their portfolios for them. We continue to recommend that investors remain at least equal weight equities and spread product in balanced portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see U.S. Investment Strategy Weekly Report, “If We Were Wrong,” published April 8, 2019. Available at usis.bcaresearch.com. 2 The survey was sent to respondents in late March. The S&P 500’s average close over the last two weeks of March was 2,823, and the survey’s bulls’ year-end and mid-2020 targets were 2,946 and 3,044, respectively.

Highlights Recent data suggest central bankers remain behind the curve in boosting inflation expectations. Ergo, expect a dovish bias to persist over the next few months. Our thesis remains that global growth is in a volatile bottoming process. However, market focus could temporarily flip towards short term data weakness, which warrants taking out some insurance. Meanwhile, in an environment where volatility is low and falling, it also pays to have insurance in place. Rising net short positioning in the yen and Swiss franc is making them attractive from a contrarian standpoint. Maintain a limit-buy on CHF/NZD at 1.45. The path of least resistance for the dollar remains down. This is confirmed by incoming data that suggests the euro area economies have bottomed, which should boost the EUR/USD. The rising dollar shortage remains a key risk to our sanguine view. But the forces driving dollar liquidity lower are largely behind us. Feature Investors looking for more clarity on the global growth picture from the April data print have been left in a quandary. In the U.S., the headline first-quarter real GDP growth number of 3.2% was well above consensus but was boosted by volatile components such as inventories and net exports. Real final sales to domestic purchasers, a cleaner print for final demand, came in at 1.5%, the lowest increase since 2015. Assuming trend growth in the U.S. is around 2%, a view shared by the Federal Open Market Committee (FOMC), then the increase in first-quarter final sales was a big miss. Most importantly, the U.S. ISM manufacturing index fell to 52.8 in April, a drop that was broad-based across seven of the 10 components. Chart I-1At The Cusp Of A V-Shaped Recovery? At The Cusp Of A V-Shaped Recovery? At The Cusp Of A V-Shaped Recovery? Across the ocean, European growth was a tad stronger. Italy managed to nudge itself out of a technical recession, while Spanish year-on-year growth of 2.4% helped drive euro area GDP growth to the tune of 1.2%. The most volatile components of euro area growth tend to be investment and net exports. Should both pick up on the back of stronger external demand, then GDP could easily gravitate towards 1.5%-2%, pinning it well above potential. The German PMI is currently one of the weakest in the euro zone. But forward-looking indicators suggest we are at the cusp of a V-shaped bottom over the next month or so (Chart I-1). China remains the epicenter of any growth pickup and the headline PMI numbers were soft, with the official NBS manufacturing PMI falling to 50.1 from 50.5, and the private sector Caixin manufacturing PMI falling to 50.2 from 50.8. Still, the numbers remain above the critical 50 threshold level, and well beyond the 45-48 danger zone. Export growth numbers across southeast Asia remain weak, and after a brisk rise since the start of the year, many China plays including commodity prices, the yuan, emerging market stocks, and Asian currencies are all rolling over. The bearish view is that there are diminishing marginal returns to Chinese stimulus, and the authorities need to be more aggressive to turn the domestic economy around. The reality is that policy stimulus works with a lag, and we need about three to six months before we see the effects of the current policy shift. Southeast Asian exports track the Chinese credit impulse with a lag of six months, and there is little reason to believe this time should be different (Chart I-2). Chart I-2Global Trade Should Soon Bottom Global Trade Should Soon Bottom Global Trade Should Soon Bottom The broad message is that global growth likely bottomed in the first quarter. However, before evidence of this fully unfolds, markets are likely to be swayed by the ebbs and flows of higher-frequency data, making for a volatile bottoming process. We recommend maintaining a pro-cyclical bias, but taking out some insurance against a potential spike in volatility.  The Fed On Hold This week’s FOMC meeting focused on the lack of inflationary pressures in the U.S. but was largely a non-event for financial markets, aside from a spike in volatility. Nonetheless, there were three key takeaways. First, the dip in inflation appears to be “transitory,” driven by lower clothing prices and financial services fees. Second, Chair Powell made it clear that the Fed will only feel the need to ease policy if inflation runs “persistently” below target. Finally, the Fed’s interpretation of its “symmetric” inflation target is slowly shifting. Many FOMC members increasingly believe that the Fed should explicitly pursue an overshoot of its 2% inflation target to make up for past misses. Taken together, we expect the Fed to remain on hold for the time being, but to eventually start raising rates again as inflationary pressures pick up. Chart I-3Inflation Should Be Higher In The U.S. Versus The Euro Area Inflation Should Be Higher In The U.S. Versus The Euro Area Inflation Should Be Higher In The U.S. Versus The Euro Area The bigger picture is that in a very globalized world with fully flexible exchange rates, it is becoming more and more difficult for any one central bank to independently achieve its inflation objective. This is because, should inflation be on the rise and moving higher in one country, expectations of higher interest rates should lift its currency, which eventually tempers inflationary pressures, and vice versa. This is obviously a very simplistic view of the world economy, since other factors such as demographics, productivity, labor mobility, openness of the economy, and policy divergences among others, play important roles. However, it is remarkable that almost every developed market central bank has continued to attempt to boost inflation to the 2% level since the Global Financial Crisis, but very few have been able to achieve this independently. In a very globalized world with fully flexible exchange rates, it is becoming more and more difficult for any one central bank to independently achieve its inflation objective.  Take the case of Europe versus the U.S., two economies that could not be more different. Euro area imports constitute about 41% of GDP, while the number in the U.S. is only 15%, so tradeable prices matter a lot more for the former. Meanwhile, the demographic profile is worse in Europe, with the old-age dependency ratio at 32% in Europe versus 23% in the U.S. Finally, other measures of supply-side constraints such as labor market slack or capacity utilization suggest the euro area is well behind the U.S. on the path toward a closed output gap (Chart I-3). Despite this, since 2015, headline inflation in both the U.S. and euro area have moved tick-for-tick. Yes, policy divergences between the two countries have been very wide, either via the lens of quantitative easing or simply the differential in policy rates (Chart I-4). But the fact that the magnitude and direction of overall inflation has moved homogenously, begs the question of the ability of either central bank to influence overall prices. One explanation could be that variations in headline CPI are largely driven by volatile items that tend to be exogenous, while variations in core CPI tend to be mostly driven by endogenous factors. This is confirmed by most research that suggest there is a weak link between rising commodity prices and longer-term inflation.1 That said, over the shorter run, commodity price gyrations can dominate and be the main driver of inflation expectations (Chart I-5). Chart I-4U.S. And Euro Area Overall CPI Are Broadly Similar U.S. And Euro Area Overall CPI Are Broadly Similar U.S. And Euro Area Overall CPI Are Broadly Similar Chart I-5In The Short Term, Commodity Prices Matter For Inflation Expectations In The Short Term, Commodity Prices Matter For Inflation Expectations In The Short Term, Commodity Prices Matter For Inflation Expectations The bottom line is that muted inflationary pressures are a global phenomenon, and not centric to the U.S. This means that as a whole, global central banks are set to stay accommodative for the time being, which will be bullish for global growth (Chart I-6). This warrants maintaining a pro-cyclical stance but being extremely selective in what might be a volatile bottoming process. Chart I-6Global Monetary Policy Needs To Ease Further bca.fes_wr_2019_05_03_s1_c6 bca.fes_wr_2019_05_03_s1_c6 Maintain A Pro-Cyclical Stance With the S&P 500 breaking to all-time highs, crude oil prices up around 40% from their lows, and U.S. 10-year Treasury yields rolling over relative to the rest of the world, this has historically been fertile ground for high-beta currency trades. That said, the lack of more pronounced strength in pro-cyclical currencies like the Australian, New Zealand, and Canadian dollars suggest that caution prevails. Our bias is that currency markets continue to fight a tug-of-war between strong dollar fundamentals and fading tailwinds. Our portfolio consists mostly of trades along the crosses, but we have been cautiously adding to U.S. dollar short positions over the past few weeks: Long AUD/USD: Our limit-buy on the Aussie was triggered at 0.70. Data out of Australia are showing tentative signs of a bottom. Last week’s important jobs report showed that the economy continues to offer more employment than the consensus expects. Meanwhile, the credit growth data out of Australia this week suggests that macro-prudential policies continue to drive a wedge between owner-occupied and investor housing (Chart I-7). House prices in Australia are already deflating to the tune of around 6%. Once the cleansing process is through, we expect house price growth to eventually converge toward levels of credit and/or natural income growth. Moreover, the Australian dollar remains a commodity currency, and will benefit from rising terms-of-trade. Iron ore prices remain firm on the back of supply-related issues. Meanwhile, a rising mix of liquefied natural gas in the export basket will provide tailwinds as China continues to steer its economy away from coal. Finally, Chinese credit growth has been a key determinant of the re-rating of Australian equities. Ergo, a rising Chinese credit impulse will ignite Australian share prices, and by extension the Australian dollar (Chart I-8). Chart I-7Australian Credit Growth Converging To Steady State Australian Credit Growth Converging To Steady State Australian Credit Growth Converging To Steady State Chart I-8More Chinese Credit Will Help Australian Equities More Chinese Credit Will Help Australian Equities More Chinese Credit Will Help Australian Equities Long GBP/USD: Our buy-limit order on the British pound was triggered at 1.30 on March 29th. As we argued back then, the pound is sitting exactly where it was after the 2016 referendum results, but the odds of a hard Brexit have significantly fallen since then. On the domestic front, economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The reality is that the pound and U.K. gilt yields should be much higher – solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape. Full-time employees continue to creep higher as a percentage of overall employment (Chart I-9). This view was echoed in yesterday’s Bank Of England (BoE) policy meeting, where the central bank raised its growth forecast while striking a more hawkish tone. Chart I-9U.K.: What Brexit? U.K.: What Brexit? U.K.: What Brexit? Chart I-10Sweden: Volatile Bottom Sweden: Volatile Bottom Sweden: Volatile Bottom   Long SEK/USD: The Swedish krona should be one of the first currencies to benefit from any bottoming in European growth (Chart I-10). The Swedish economy appears to have bottomed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, the cross is trading at its lowest level since the global financial crisis (Chart I-11). Economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The main appeal of the Swedish krona is that it is extremely cheap. Meanwhile, despite negative interest rates, Swedish household loan growth has been slowing as consumers are increasingly financing purchases through rising wages. This will alleviate the need for the Riksbank to maintain ultra-accommodative policy, despite its recent dovish shift. Buy Some Insurance Given current low levels of volatility and elevated equity market valuations, the dollar would have been a great insurance policy for any stock market correction. But with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs.  Chart I-11How Much Lower Could The Swedish Krona Go? How Much Lower Could The Swedish Krona Go? How Much Lower Could The Swedish Krona Go? Chart I-12Buy Some##br## Insurance Buy Some Insurance Buy Some Insurance It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. As markets become volatile and some carry trades are unwound, unhedged trades will become victim to short-covering flows. Currencies such as the Japanese yen and the Swiss franc that could have been used to fund carry trades are ripe for reversals. This suggests at a minimum building some portfolio hedges. One such hedge is going long the CHF/NZD. This trade has a high negative carry, so we do not intend to hold it for longer than three months. But it should pay off handsomely on any rise in volatility (Chart I-12). Maintain a limit-buy at 1.45.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Stephen G Cecchetti and Richhild Moessner, “Commodity Prices And Inflation Dynamics,” Bank Of International Settlements, Quarterly Review, (December 2008). Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. continue to moderate: Annualized Q1 GDP came in at 3.2% quarter-on-quarter, well above estimates. Personal income increased by 0.1% month-on-month in March, below the estimated 0.4%. On the other hand, personal spending increased by 0.9% month-on-month in March. PCE deflator and core PCE deflator fell to 1.5% and 1.6% year-on-year, respectively in March. Michigan consumer sentiment index slightly increased to 97.2 in April. Markit manufacturing PMI increased from 52.4 to 52.6 in April, while ISM manufacturing PMI fell to 52.8. Q1 nonfarm productivity increased by 3.6%, surprising to the upside. DXY index fell by 0.3% this week. On Wednesday, the Fed announced their decision to keep interest rates on hold at current levels, further suggesting that there is no strong case to move rates in either direction based on recent economic developments. Moreover, Fed chair Powell reiterated their strong commitment to the 2% inflation target. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area are improving: Money supply (M3) in the euro area increased by 4.5% year-on-year in March. The sentiment in the euro area remains soft in April: economic sentiment indicator fell to 104; business climate fell to 0.42; industrial confidence fell to -4.1; consumer confidence was unchanged at -7.9. Q1 GDP came in at 1.2% year-on-year, surprising to the upside. Unemployment rate fell to 7.7% in March. Markit PMI increased to 47.9 in April. EUR/USD appreciated by 0.3% this week. European data keep grinding higher. Italian GDP moved back into positive territory in Q1. Spanish GDP also rebounded in Q1. Positive Chinese credit data suggests the euro will soon benefit from rising Chinese imports.  Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been positive: The unemployment rate in March increased slightly to 2.5%; job-to-applicant ratio was unchanged at 1.63. Tokyo consumer price inflation increased to 1.4% year-on-year in March, the highest level since October 2018. Industrial production fell by 4.6% year-on-year in March. However, projections for April suggest a 2.7% month-on-month jump. Retail sales grew by 1% year-on-year in March, higher than expected. Housing starts grew by 10% year-on-year in March. This is the highest growth level since February 2017. USD/JPY fell by 0.2% this week. The Japanese government’s intention to raise sales tax this October could be a highly deflationary outcome. However, there is still an outside chance that the tax hike will be postponed. We continue to recommend yen as a safety hedge. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been positive: U.K. mortgage loans in March increased to 40K.  Nationwide housing prices increased by 0.9% on a year-on-year basis in April. Markit manufacturing PMI came in above expectations at 53.1 in April, even though it fell; Markit construction PMI however increased to 50.5. Money supply (M4) increased by 2.2% year-on-year in March. GBP/USD increased by 1% this week. The Bank of England kept rates on hold at 0.75% this week. In the May inflation report, the BoE mentioned that U.K.’s economic outlook will depend significantly on the nature and timing of EU withdrawal, and the new trading agreement with EU in particular. But governor Carney struck a slightly hawkish tone, revising up GDP estimates and guiding the next policy move as a rate hike. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have shown tentative signs of recovery: Private sector credit growth fell to 3.9% year-on-year in March. However, this is heavily biased downwards by lending to home investors that has slowed to a crawl. The Australian Industry Group (AiG) manufacturing index increased to 54.8 in April. RBA commodity index increased by 14.4% year-on-year in April. AUD/USD fell by 0.4% this week. The data are starting to look brighter in Q2, suggesting that the economy might have bottomed in Q1. The Australian dollar is likely to grind higher, especially driven by rising terms of trade. Report Links: Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand are mixed: ANZ activity outlook increased by 7.1% in April. ANZ business confidence in April improved to -37.5. On the labor market front in Q1, the employment change fell to 1.5% year-on-year; unemployment rate was unchanged at 4.2%, but participation rate fell to 70.4%; labor cost index fell to 2% year-on-year. Building permits contracted by 6.9% month-on-month in March. NZD/USD depreciated by 0.4% this week. The data from New Zealand continue to underperform its antipodean neighbor. We anticipate this trend will persist. Stay long AUD/NZD, currently 0.5% in the money. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada continue to underperform: GDP in February contracted by 0.1% on a month-on-month basis. Markit manufacturing PMI fell below 50 to 49.7 in April.  USD/CAD fell by 0.1% this week. During Tuesday’s speech, Governor Poloz acknowledged recent negative developments in the Canadian economy, and blamed it on the U.S.-led trade war, as well as the sharp decline in oil prices late last year. While a bottoming in the global growth could be a tailwind for the Canadian economy near-term, a Ricardian equivalence framework will suggest fiscal austerity over the next few years, will be a headwind for long-term CAD investors. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell to 96.2 in April. Real retail sales contracted by 0.7% year-on-year in March. SVME PMI fell below 50 to 48.5 in April. USD/CHF fell by 0.1% this week. The reduced volatility worldwide could make the Swiss franc less attractive. Moreover, the relative outperformance of the euro area is a headwind for the franc. Our long EUR/CHF position is now 1% in the money. We intend to trade the franc purely as an insurance policy near-term. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Retail sales increased by 0.6% in March, in line with expectations. This was a marked improvement from the 1.2% drop in February. The unemployment rate held low at 3.8% USD/NOK increased by 1% this week. We expect the Norwegian krone to pick up based on the strong fundamentals and positive oil price outlook. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mostly positive: Retail sales increased on a month-on-month basis by 0.5% in March, but fell to 1.9% on a yearly basis. Producer price index was unchanged at 6.3% year-on-year in March. Trade balance came in at a large surplus of 7 billion SEK in March. Manufacturing PMI fell to 50.9 in April, but notably, import orders and backlog orders rose.  USD/SEK increased by 0.4% this week. Despite the RiksBank’s dovish shift last week, we continue to favor our long SEK position. Our conviction is rooted in the fact that the Swedish krona is undervalued, and relative PMI trends favor Sweden vis-à-vis the U.S. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights This week’s FOMC meeting confirmed that the Fed is on hold. We would downplay Powell’s reference to the decline in inflation as being “transitory”. Strictly speaking, he is correct. All of the decline in core inflation since last September has occurred in just two categories: financial services and clothing/footwear. The bigger point is that the Fed no longer sees fit to raise rates even though the unemployment rate is at a 50-year low and real rates are barely positive. Both the Fed and the markets have completely bought into two of Larry Summers’ core views, which are that the neutral rate of interest is much lower today than in the past, and that the Fed should wait to see the “whites of inflation’s eyes” before raising rates any further. We think the neutral rate will prove to be higher than widely believed and that the Fed will eventually find itself far behind the curve. Risk assets may see heightened volatility over the next few days as markets adjust to the fact that rate cuts are not forthcoming. Nevertheless, with rates still far below our estimate of neutral, the path of least resistance for global equities remains to the upside. The bull market in stocks will only end when inflation moves significantly higher, requiring the Fed to hike rates aggressively. That is unlikely to happen during the next 12 months. Feature Gentle Jay Ruffles The Markets … Transitorily This week’s FOMC statement confirmed that the Fed is on hold. In sharp contrast to his claim last October that rates were “a long way from neutral,” Chair Powell stressed during his press conference that there was no strong case for moving rates in “either direction.” Equities initially rose, while the dollar weakened, only to reverse direction following Powell’s subsequent comment that the recent decline in inflation was “transitory.” We would not make a big deal of Powell’s “transitory” remark. As a factual matter, he is correct. Table 1 shows that almost all of the decline in core PCE inflation from 2% in September 2018 to 1.6% in March 2019 can be explained by a drop in inflation in two categories: financial services and clothing/footwear. The former was weighed down by the steep decline in equity prices late last year (Chart 1). The latter was affected by a methodological change in how the Bureau of Labor Statistics calculates apparel prices.1    Table 1Weaker Core PCE Inflation Driven Mainly By Financial Services Larry Summers: Shadow Fed Chair Larry Summers: Shadow Fed Chair Chart 1Stock Market Swings Feed Into Price Indices Stock Market Swings Feed Into Price Indices Stock Market Swings Feed Into Price Indices The more important takeaway is that the Fed is now in a “wait and see” mode. Considering that the unemployment rate is at a 50-year low and real rates are barely positive, this is an extraordinary development. How to explain it? Two words: Larry Summers. Everyone Loves Larry Six years after President Obama dashed Larry Summers’ hopes of becoming the next Fed chair by anointing Janet Yellen instead, the former Treasury Secretary’s shadow hangs over the central bank like never before. Two of Summers’ key views – that the neutral rate of interest is much lower today than in the past, and that the Fed should wait to see the “whites of inflation’s eyes” before raising rates any further – have become accepted wisdom not just at the Fed, but on Wall Street as well. At the same time, another of Larry Summers’ core beliefs, that the Fed should aim for an inflation rate above the current target of 2%, is gaining traction.   This raises an important question: What would it mean for investors if all these hypotheses turned out to be wrong? Let’s examine the arguments. How Low Is The Neutral Rate Of Interest? Conceptually, the interest rate on safe government securities should adjust to ensure that global savings equal investment. Interest rates will fall if either desired savings rise or desired investment declines (Chart 2). To the extent that some countries have more savings and/or fewer worthwhile domestic investment opportunities than others, they will run current account surpluses. Countries with less savings and better investment prospects will run current account deficits (Chart 3). Chart 2 Chart 3 There is a strong case to be made that the neutral rate of interest has fallen over the past few decades. Potential GDP growth in developed economies has slowed. This has reduced the need for new capital investment. The advent of the digital age, or the “demassification” of the economy as Summers calls it, has also brought down the amount of physical capital firms need to function. Meanwhile, China’s entry into the global economy greatly expanded productive capacity without a concomitant increase in spending, thus creating the “savings glut” that Ben Bernanke first described in 2005. The question is how will these forces evolve over the coming years? According to the standard “accelerator” model, the optimal level of investment spending is determined by the growth rate of aggregate demand.2 As Chart 4 illustrates, most of the decline in trend real GDP growth in developed economies occurred between 1960 and 2000. Growth may decelerate further over the next decade, but not by much. Chart 4 Chart 5Dependency Rates Are Rising Again In Developed Economies Dependency Rates Are Rising Again In Developed Economies Dependency Rates Are Rising Again In Developed Economies   Investment growth in China is likely to slow, but savings could also decline as a more robust consumer culture emerges and the government continues to take steps to strengthen the social safety net. Population aging in China and elsewhere could also erode savings. Falling fertility rates in most of the world starting in the early 1960s led to a decline in dependency rates in the 1980s and 1990s (Chart 5). However, now that baby boomers are starting to retire, dependency rates are rising. Once health care spending is included, consumption increases in old age, especially in the last few years of life (Chart 6). Globally, the ratio of workers-to-consumers peaked earlier this decade. The pace of the decline in this ratio is set to accelerate over the next few decades (Chart 7). More desired consumption relative to any given level of production implies less savings and a higher neutral rate of interest. Chart 6Savings Over The Life Cycle Savings Over The Life Cycle Savings Over The Life Cycle Chart 7The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally   Even in Japan, the neutral rate may be stealthily moving higher (Chart 8). Despite an influx of women into the labor market, the household savings rate has fallen from nearly 20% in the early 1980s to around 4% of late. The ratio of job openings-to-applicants has risen to a 45-year high. The trade balance has moved into deficit. Yet, 20-year inflation swaps are trading at 0.3%, implying that investors do not expect the Bank of Japan to achieve its 2% inflation target anytime soon. They may be in for a big surprise. Gauging The Cyclical Drivers Of The Neutral Rate At its core, the secular stagnation thesis is a theory about the long-term determinants of interest rates. It says little about the appropriate level of interest rates over cyclical horizons of a few years, even though that is the period over which monetary policy decisions tend to affect the economy. Today, aggregate demand in the United States is being buoyed by a number of cyclical forces. These include very loose fiscal policy, fairly strong credit growth (especially among corporates), high levels of asset prices, and faster wage growth at the bottom of the income distribution (Chart 9). All of these forces are helping to lift the neutral rate of interest. Chart 8Japan May Be Slowly Moving Towards Higher Inflation Japan May Be Slowly Moving Towards Higher Inflation Japan May Be Slowly Moving Towards Higher Inflation Chart 9U.S.: Cyclical Forces Are Propping Up Demand U.S.: Cyclical Forces Are Propping Up Demand U.S.: Cyclical Forces Are Propping Up Demand Consider the impact of looser fiscal policy. The IMF estimates that the U.S. structural budget deficit averaged 3.2% of GDP in 2015. In 2019, the IMF reckons it will average 5.2% of GDP. The budget deficit could rise further if Trump and Congress succeed in negotiating a new infrastructure package or if, as is likely, the Democrats insist on new spending measures as a condition for increasing the debt ceiling later this year. For the sake of argument, let us suppose that every $1 of additional fiscal stimulus adds $1 to aggregate demand. In this case, fiscal policy has added about 2% of GDP to annual aggregate demand over the past five years. Suppose that a one percentage-point increase in aggregate demand raises the appropriate level of interest rates by one percentage point, which is in line with the specification of the Taylor Rule that former Fed Chair Janet Yellen favored. This implies that fiscal policy alone has raised the neutral rate by over two percentage points over this time period. Laubach-Williams And The Fed Pause The discussion above suggests that the neutral rate of interest may be much higher than what the widely-used Laubach-Williams (LW) model implies. The LW model essentially calculates the trend growth rate of the economy in order to come up with its estimate for the neutral rate (Chart 10). It is an overly simplistic approach, as it ignores all the other factors influencing savings and investment decisions. Nevertheless, it seems to be driving the Fed’s thinking to a significant degree. Chart 10 Chart 11Things That Make The Fed Go "Hmm"... Things That Make The Fed Go "Hmm"... Things That Make The Fed Go "Hmm"... The real fed funds rate reached the LW estimate for the first time in 11 years last December (Chart 11). While we would not go as far as crediting the model for the Fed’s decision to go on hold – the sell-off in stocks and the flattening of the yield curve played a much larger role – the Fed’s reliance on the model does explain why it has maintained a dovish stance this year even as financial conditions have eased. Waiting For The Whites Of Inflation’s Eyes To his credit, John Williams, who helped develop the model more than 15 years ago, and now serves as the President of the New York Fed and the Vice Chair of the FOMC, has stressed that there is a wide band of uncertainty around any estimate of the neutral rate. Given this inherent uncertainty, a growing number of policymakers have shifted towards the Summers view that it is better to err on the side of caution and take a go-slow approach to raising rates. The rationale is straightforward: If the neutral rate turns out to be higher than expected and inflation starts to accelerate, central banks can always tighten monetary policy. In contrast, if the neutral rate is very low, the decision to raise rates could plunge the economy into a downward spiral. Historically, the Fed has cut rates by about six percentage points during recessions (Chart 12). At present rates of inflation, that would surely mean that the zero lower bound on interest rates would be reached, at which point monetary policy becomes increasingly impotent. Chart 12The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound A major drawback to waiting too long to raise rates is that it can take up to 18 months for changes in monetary policy to affect the economy. Inflation is also a highly lagging indicator: It normally does not peak until after a recession has begun, and does not bottom until the recovery is well underway (Chart 13). By the time you realize that the economy is overheating, it may be too late to prevent inflation from rising. Chart 13 Of course, in the minds of many influential economists, higher inflation would be a virtue rather than a vice. Summers has argued that the Fed should aim to bring inflation into a range of 3%-to-4% in order to ensure that real rates can fall far enough into negative territory during the next recession. Higher inflation could also alleviate the nominal wage rigidity problem, thus allowing real wages to adjust more readily in response to economic shocks. The risk of aiming for higher inflation is that you will get more of it than you bargained for. True, inflation was broadly stable in the mid-to-late 1980s at around 4%, but this followed a period of much higher inflation in the late 1970s/early 1980s (Chart 14). It may be more difficult to stabilize inflation after it has risen than after it has fallen. This is especially likely to be the case if the central bank has purposely taken steps to raise inflation. Chart 14Inflation Was Broadly Stable At Around 4% In The Mid-To-Late 1980s Inflation Was Broadly Stable At Around 4% In The Mid-To-Late 1980s Inflation Was Broadly Stable At Around 4% In The Mid-To-Late 1980s Supersymmetry: Inflation Edition The Fed is not about to raise its inflation target anytime soon. It is, however, rethinking the manner in which it conducts monetary policy in a way that will probably lead to somewhat higher inflation. Under the Fed’s existing framework, its “symmetric” inflation target is not supposed to be backward-looking. Symmetry simply means that the Fed targets 2% inflation every year, allowing for an equal probability of inflation ending up overshooting its mark as undershooting it. If inflation has missed its target in the past, this does not give the Fed license to try to exceed it in the future. Bygones are bygones. Chart 15 Chart 16Inflation Has Been Below The Fed's 2% Target For The Past 10 Years Inflation Has Been Below The Fed's 2% Target For The Past 10 Years Inflation Has Been Below The Fed's 2% Target For The Past 10 Years This definition of symmetry is starting to shift to one that is both forward-looking and backward-looking. This effectively brings the Fed one step closer to adopting price-level targeting – an idea John Williams has spoken glowingly about. Under a price-level targeting regime, the Fed would try to keep the price level on a predetermined trend (Chart 15). Inflation undershoots would have to be rectified with overshoots, and vice versa. This is obviously relevant for the current environment. Chart 16 shows that the core PCE deflator is now 4.6% below where it would have been if it increased by 2% per year since the financial crisis. Even if the Fed did not change its inflation target, bringing the deflator back towards its pre-crisis trend would still require that inflation run above the Fed’s target over the next few years. As Neel Kashkari said earlier this year: “We officially have a symmetric target and actual inflation has averaged around 1.7%, below our 2% target, for the past several years.  So if we were at 2.3% for several years that shouldn't be concerning.”3 Investment Conclusions Risk assets may see heightened volatility over the next few days as markets adjust to the fact that rate cuts are not forthcoming. Nevertheless, with rates still far below our estimate of neutral, the path of least resistance for global equities remains to the upside. Recessions typically do not occur when monetary policy is accommodative. The stock market, in turn, rarely falls in a sustained manner when the economy is expanding (Chart 17). This view prompted us to upgrade global equities in December. We remain cyclically bullish today. Chart 17Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Regionally, we do not have any strong preferences at the moment, but expect to upgrade EM and Europe by this summer. Despite the occasional disappointment such as this month’s manufacturing ISM, a broad swath of the evidence suggests global growth is reaccelerating (Chart 18). EM and European stocks tend to outperform in that environment. The dollar tends to weaken when the global economy strengthens (Chart 19). Hence, the greenback should enter a soft patch over the coming months which could last until the second half of next year. Chart 18Global Growth Is Reaccelerating Global Growth Is Reaccelerating Global Growth Is Reaccelerating Chart 19The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Global bond yields will drift higher over the coming months as global growth surprises on the upside. Investors should position for somewhat steeper yield curves globally. The U.S. yield curve will flatten again late next year as inflation starts to reach levels that even a dovish Fed is not comfortable with. This will likely set the stage for an inversion of the yield curve in early 2021 and a global recession later that same year.    Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      “Government Economists Turn to Big Data to Track the Economy,” The Wall Street Journal, April 30, 2019. 2       In most economic models, the capital-to-output ratio is assumed to converge towards a stable level over time. By definition, the capital stock in Year t is determined by the capital stock in Year t-1 plus whatever net investment (gross investment minus depreciation) takes place in Year t. In general, the optimal net investment-to-GDP ratio will equal the product of the capital-to-output ratio and the growth rate of GDP. For example, suppose that the capital-to-output ratio is three (meaning that the capital stock is three times as large as GDP). If output does not change from one year to the next, no additional net investment would be necessary to maintain a stable capital-to-output ratio. However, if output is growing at 2%, net investment of 3X2%=6% of GDP would be required. 3      “Fed's Kashkari says some overshoot on inflation would not be alarming,” Reuters, April 11, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 20 Tactical Trades Strategic Recommendations Closed Trades

Highlights Open an equity market relative overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, the majority of this year’s absolute gains have already been made. Core euro area bond yields will edge modestly higher… …and EUR/USD will appreciate, as the backward-looking data on which the ECB depends catches up with the more perky real-time economic data.   Feature Vertical charts scare us, as we contemplate falling over the edge. But they also excite us, as we contemplate a lucrative investment opportunity. Right now, the vertical chart that is causing us palpitations is technology versus healthcare (Chart of the Week).  Chart of the WeekTechnology Versus Healthcare Has Gone Vertical! Technology Versus Healthcare Has Gone Vertical! Technology Versus Healthcare Has Gone Vertical! The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Meaning that the technology versus healthcare relative performance has unavoidable consequences for regional and country stock market allocation (Chart I-2 and Chart I-3). The technology versus healthcare sector pair is critical, because it looms large in several stock markets’ ‘fingerprint’ sector skews. Chart I-2When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland When Technology Underperforms Healthcare, Netherlands Underperforms Switzerland Chart I-3When Technology Underperforms Healthcare, China Underperforms Switzerland When Technology Underperforms Healthcare, China Underperforms Switzerland When Technology Underperforms Healthcare, China Underperforms Switzerland Specifically, from a European stock market perspective, the Netherlands is overweight technology while Switzerland and Denmark are both overweight healthcare. Further afield, the U.S. is overweight technology while China is both overweight technology and underweight healthcare. Explaining Verticality And The Subsequent Fall What creates vertical charts? To answer the question, let’s turn it on its head: what prevents vertical charts? The answer is: the presence of value investors. In a healthy market, a cohort of value investors will sit on the side lines and only transact with the marginal seller when the price falls to a semblance of value. In other words, the value sensitive investors help to set the price, preventing verticality. But if the value sensitive cohort switches out of character to join a strong uptrend, the cohort will suddenly become value insensitive. In this case, the marginal seller will set the price higher and the formerly uninterested value sensitive buyer will now buy at the higher price. The market has morphed into a trend-following market. As more of the value cohort switch sides, the process adds rocket fuel to the rally. Driven by the ‘fear of missing out’ the marginal buyer will buy at larger and larger price increments, and the chart becomes vertical. What triggers the subsequent fall? When all of the value cohort have joined the uptrend, the fuel has run out: the marginal seller will no longer find a willing marginal buyer at the elevated price. At this critical point, one of two things will happen. Either: a completely new cohort of even deeper value investors will switch out of character and provide new fuel to the trend, allowing it to continue. Or: the deep value investors will stay true to character and will only deal with the marginal seller when the price falls, perhaps sharply, to a semblance of deep value. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased. Both the theoretical and empirical evidence suggests that at this critical point, the probability of trend-continuation decreases to about a third and the probability of a trend-reversal increases to about two-thirds. Technology versus healthcare is now at this critical technical point at which the probability of trend-reversal has significantly increased (Chart I-4). Chart I-4Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Technology Versus Healthcare: The Probability Of A Trend-Reversal Is High Therefore, on a tactical horizon, it is now appropriate to underweight technology versus healthcare – which, to reiterate, carries unavoidable consequences for country and regional stock market allocation: Open an overweight to Europe versus China. Upgrade Denmark to neutral. Downgrade the Netherlands to underweight. Maintain Switzerland at overweight. Distinguishing Between Valuation And Growth Is Extremely Difficult There is another problem for value investors. Over short periods – meaning less than a year – it is very difficult, if not impossible, to decompose a price return into its two components: the component coming from the change in valuation and the component coming from the change in earnings growth expectations. A stock market’s actual earnings are highly sensitive to small changes in economic growth. This is universally the case but is especially true in Europe, because the European stock market’s skew towards growth-sensitive cyclicals gives it a very high operational leverage to GDP growth: a seemingly minor 0.5 percent change in economic growth translates into a major 25 percent change in stock market earnings growth (Chart I-5). The slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Chart I-5A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth A Minor Upgrade To Economic Growth = A Major Upgrade To Profits Growth Given this very high operational leverage, the slightest improvement in economic growth expectations causes the market to upgrade its forecasts for earnings very sharply. Which of course lifts the market’s price, P, very sharply. In contrast, equity analysts’ forecasts for earnings, which drive the market’s ‘official’ forward earnings, E, adjust much more slowly. As my colleague, Chris Bowes explains: “analysts get married to a view and usually require overwhelming evidence to materially change it.” The upshot is that the P rises very sharply but the official forward E does not, meaning that the official forward P/E also rises very sharply. This gives the impression that the move is mostly valuation driven, but the truth is that the move is mostly earnings growth driven. In a similar vein, when central banks guide interest rates lower, how much of the equity market’s move is due to a higher valuation, and how much is due to improved prospects for economic growth resulting from the central bank policy change? Over relatively short periods of time, it is extremely difficult to tell. All of which provides an important lesson: over short periods, do not focus on separately forecasting the valuation change and earnings growth change of a stock market. Much better to forecast the stock market price directly, by focussing on the two main things which will drive it: changes to central bank policy, and changes to short-term real-time economic growth. Focus On Central Banks And Short-Term Economic Growth Central bank policy now ‘depends’ on relatively longer-term changes (say, year-on-year) in backward-looking data, most notably the consumer price index. Whereas the stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators (Chart I-6). Chart I-6Quarter-On-Quarter Growth Is Rebounding Quarter-On-Quarter Growth Is Rebounding Quarter-On-Quarter Growth Is Rebounding Hence, the ‘sweet spot’ for equity markets is when, in simple terms, year-on-year CPI inflation is decelerating, implying central banks will become more dovish, while quarter-on-quarter economic growth is accelerating, implying the market will upgrade earnings growth (Chart I-7). The stock market’s earnings growth expectations take their cue from shorter-term changes in real-time economic indicators. The ‘weak spot’ for equity markets is the exact opposite, when year-on-year CPI inflation is accelerating, implying central banks will become less dovish, while quarter-on-quarter economic growth is decelerating, implying the market will downgrade earnings growth. As 2019 progresses, our high-conviction prediction is that equity markets will move from a sweet spot to a weak spot. With the Euro Stoxx 50 now up almost 20 percent from its January 3 low, it implies that the majority of 2019’s gains have already been made in the first four months of the year – and the market is unlikely to be significantly higher at the end of the year. Compared to the equity market, the bond, interest rate, and currency markets are – almost by definition – much more dependent on central banks’ lagging reaction functions than on real-time growth. Which solves the mystery as to why bond yields are close to new lows while equity markets are close to new highs. It also solves the mystery as to why EUR/USD has lagged the very clear recovery in euro area real-time growth and in euro area stock markets (Chart I-8). Central banks are following lagging indicators. Chart I-7Stock Markets Take Their Cue from Real-Time Indicators Stock Markets Take Their Cue from Real-Time Indicators Stock Markets Take Their Cue from Real-Time Indicators Chart I-8Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators Central Banks Are Following Lagging Indicators, Stock Markets Are Following Real-Time Indicators But as the backward-looking data, on which the ECB depends, catches up with the more perky real-time data, core euro area bond yields will edge modestly higher, and EUR/USD will gently appreciate. Next week, in lieu of the usual weekly report, I will be giving this quarter’s webcast titled ‘From Sweet Spot to Weak Spot?’ live on Wednesday May 8 at 10.00 AM EDT (3.00 PM BST, 4.00 PM CEST, 10.00 PM HKT). Through a series of key charts, the webcast will reveal the prospects and opportunities for all asset-classes through the remainder of 2019. At the end of the webcast, I will also unveil a brand new investment recommendation. So don’t miss it! Fractal Trading System* Supporting the arguments in the main body of this report, fractal analysis suggests that the recent rally in China’s stock market is at a technical point that has reliably signaled previous major reversals. Accordingly, this week’s recommended trade is a stock market pair trade, short China versus Japan. Set the profit target at 2.5 percent with a symmetrical stop-loss. We now have six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9Short China Vs. Japan Short China VS. Japan Short China VS. Japan   The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * 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 Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Highlights Fed: Fed policymakers are sending a unified message that they want to keep rates on hold until they see a significant increase in inflation. However, our reading of their recent remarks suggests that they will be reluctant to actually cut rates unless GDP growth falls to below its estimated potential. Economy: If we strip out the volatile net exports, government and inventory components of growth, we see that economic activity slowed to below potential in the first quarter. However, the timeliest data on consumer spending, nonresidential investment and residential investment all suggest that Q1 will be the trough for the year. All in all, economic growth should be comfortably above potential in 2019, keeping rate cuts at bay. Investment Strategy: Investors should keep portfolio duration low, avoiding the 5-year/7-year part of the Treasury curve. Investors should also overweight spread product versus Treasuries, with a focus on Baa and junk rated corporate bonds. Feature Since January, Federal Reserve policymakers have sent a strikingly unified message: Policy should remain “patient” in an effort to re-anchor inflation expectations and demonstrate the symmetry of the Fed’s 2 percent inflation target. Take for example, two excerpts from recent speeches by Boston Fed President Eric Rosengren and Chicago Fed President Charles Evans. Rosengren:1 My own preference is for the Federal Reserve to adopt an inflation range that explicitly recognizes the challenge of the effective lower bound. We might be forced to accept below-2-percent inflation during recessions, but we would commit to achieving above-2-percent inflation in good times, so as to provide more policy space to counteract the next recession. Evans:2 I think the Fed must be willing to embrace inflation modestly above 2 percent 50 percent of the time. Indeed, I would communicate comfort with core inflation rates of 2-1/2 percent, as long as there is no obvious upward momentum and the path back toward 2 percent can be well managed. The consensus appears to be not only that higher inflation is necessary before the Fed lifts rates again, but also that the Fed should explicitly target an overshoot of its 2 percent target. With trailing 12-month core PCE inflation running at only 1.55% as of March, it will undoubtedly take some time before these inflation goals are met. We think the Fed’s commitment to keeping rates steady could waver if financial conditions ease sufficiently.3 But for now, with the market priced for 36 basis points of rate cuts over the next 12 months, the more pertinent question is: What will it take for the Fed to lower rates from current levels? Expecting A Rate Cut? Don’t Hold Your Breath Our Fed Monitor has an excellent track record calling turning points in monetary policy, and at present it is very close to zero, consistent with the Fed’s “on hold” stance (Chart 1). The Monitor is comprised of 44 indicators of economic growth, inflation and financial conditions. In other words, for the Monitor to recommend rate cuts going forward we will need to see some further deterioration in either economic growth, inflation or financial markets (Chart 2). This is roughly consistent with how Chicago Fed President Evans described his reaction function in his speech from two weeks ago: Chart 1"On Hold" Stance Justified "On Hold" Stance Justified "On Hold" Stance Justified Chart 2Fed Monitor Components Fed Monitor Components Fed Monitor Components If growth runs close to or somewhat above its potential and inflation builds momentum, then some further rate increases may be appropriate over time… In contrast, if activity softens more than expected or if inflation and inflation expectations run too low, then policy may have to be left on hold – or perhaps even loosened – to provide the appropriate accommodation to obtain our objectives. Our interpretation of the Fed’s reaction function is that it wants to maintain an accommodative monetary policy to ensure that inflation and inflation expectations move higher over time. However, it will consider monetary policy to be accommodative as long as GDP growth stays close to, or above, estimates of its potential rate. In other words, while the Fed is in no rush to tighten, we probably need to see a significant period of below-potential GDP growth before rate cuts are on the table. In his speech, Evans indicates that his personal estimate of potential GDP growth is 1.75%. The March Summary of Economic Projections shows that the central tendency of FOMC participant estimates is 1.8% - 2%. Our view is that U.S. growth will easily surpass this threshold in 2019, keeping rate cuts at bay. Tracking U.S. Growth Markets were caught off guard last week when we learned that real GDP grew 3.17% in the first quarter, above consensus estimates and well above the 1.8% - 2% potential growth threshold. However, the headline Q1 figure was flattered by significant gains in a few volatile GDP components. Chart 3Underlying Growth Slowdown Underlying Growth Slowdown Underlying Growth Slowdown Much like how core measures of inflation strip out volatile food and energy prices to give us a better sense of the underlying trend, we can also look at Real Final Sales To Domestic Purchasers (FSDP) to get a better sense of the underlying trend in economic growth. FSDP includes only consumer spending, nonresidential investment and residential investment. That is, it removes government spending, net exports and inventory investment from the overall number. Viewed this way, we see that the U.S. economy did experience a significant growth slowdown in the first quarter. Real FSDP grew only 1.45% in Q1, below the 1.8% - 2% potential growth threshold (Chart 3). Net Exports & Inventories Chart 4Net Exports & Inventories Net Exports & Inventories Net Exports & Inventories First quarter GDP was boosted by a +1.03% contribution from net exports and a +0.65% contribution from inventory investment, neither of which is likely to be repeated in Q2 (Chart 4). The top panel of Chart 4 shows just how unusual it is to see such a large contribution from net exports, an event that becomes even less likely when you factor in the dollar’s recent appreciation (Chart 4, panel 2). Turning to inventories, a significant build was long overdue given the backlog of orders seen during the past two years. But the ISM Manufacturing Index’s backlog of orders component has now fallen back to a neutral level (Chart 4, bottom panel). This suggests that firms are comfortable with their current inventory stockpiles, and that no aggressive inventory increases are likely during the next few quarters. Interestingly, while net exports and inventories will almost certainly pressure GDP growth lower in Q2, back toward the growth rate in FSDP, the latter has probably already troughed for the year. Recent data on consumer spending, nonresidential investment and residential investment all appear to have turned a corner. Consumer Spending Consumer spending added a meager +0.8% to GDP in Q1, but core retail sales growth has recovered sharply after having plunged near the end of last year (Chart 5). What’s more, with consumer sentiment close to one standard deviation above its historical mean – whether we look at expectations or current conditions surveys – consumers don’t seem inclined to retrench in the months ahead (Chart 6). Chart 5Consumer Spending Consumer Spending Consumer Spending Chart 6Buoyant Consumer Sentiment Buoyant Consumer Sentiment Buoyant Consumer Sentiment Nonresidential Investment Chart 7Nonresidential Investment Nonresidential Investment Nonresidential Investment We expected business investment to weaken in Q1, and its +0.4% growth contribution is low compared to recent readings. The decline was anticipated due to last year’s significant deterioration in global growth. Slower global growth necessarily causes firms to downgrade their profit expectations. Faced with lower expected profits, companies are much more inclined to curtail investment. However, considering the outlook heading into mid-year, we have already noticed signs of improvement in leading global growth indicators.4 More recently, we have even seen that improvement translate into stronger U.S. investment data. Core durable goods new orders grew +17% (annualized) in March, dragging the year-over-year rate up to +5.3% (Chart 7). Further, our BCA Composite New Orders Indicator – a weighted combination of ISM New Orders and NFIB Capital Spending Plans – has bounced during the past few months, returning close to its historical mean (Chart 7, panel 3). An average of Capital Spending Intentions from regional Fed surveys also remains close to one standard deviation above its historical average (Chart 7, bottom panel). Residential Investment Residential investment (aka Housing) has exerted a meaningful drag on GDP growth in each of the past five quarters, and it lowered GDP by -0.1% in Q1 (Chart 8). However, much like with consumer spending and nonresidential investment, the timely economic data suggest a turnaround is in the offing. Much like with consumer spending and nonresidential investment, the timely economic data suggest a turnaround is in the offing. Optimism has returned to housing since mortgage rates fell earlier this year. New home sales and mortgage purchase applications have jumped, and single-family housing starts are the only important housing-related data that haven’t yet rebounded. We expect that rebound to occur soon, as do homebuilders whose confidence has risen during the past few months. Homebuilder optimism surveys remain close to one standard deviation above their historical averages (Chart 9). Chart 8Residential Investment Residential Investment Residential Investment Chart 9Buoyant Homebuilder Confidence Buoyant Homebuilder Confidence Buoyant Homebuilder Confidence Bottom Line: Fed policymakers are sending a unified message that they want to keep rates on hold until they see a significant increase in inflation. However, our reading of their recent remarks suggests that they will be reluctant to actually cut rates unless GDP growth falls to below its estimated potential. Potential GDP growth is estimated to be in the 1.8% to 2% range. If we strip out the volatile net exports, government and inventory components of growth, we see that economic activity slowed to below potential in the first quarter. However, the timeliest data on consumer spending, nonresidential investment and residential investment all suggest that Q1 will be the trough for the year. All in all, economic growth should be comfortably above potential in 2019, keeping rate cuts at bay. Investment Implications To translate the above views on the economy and the Fed’s reaction function into a portfolio strategy, we first return to our Golden Rule of Bond Investing.5The Golden Rule states that if the Fed delivers more (fewer) rate hikes than are currently discounted in the market over the next 12 months, then the Treasury index will earn negative (positive) excess returns versus cash during that investment horizon (Chart 10). At present, this means that investors should only expect positive excess returns from taking duration risk in the event that the Fed cuts rates by more than 36 basis points during the next 12 months. Given our view that rate cuts are unlikely, investors should maintain below-benchmark portfolio duration. Chart 10The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record If we further assume that market expectations will shift to price-in fewer rate cuts, or even possibly some rate hikes, then we would expect 5-year and 7-year yields to rise the most (Chart 11). Investors should avoid those maturities and focus their Treasury exposure on the short and long ends of the curve. These barbell over bullet trades have the advantage of being positive carry, so they will earn money even if rate hike expectations are unchanged.6  Chart 11Avoid The 5- And 7-Year Maturities Avoid The 5- And 7-Year Maturities Avoid The 5- And 7-Year Maturities Chart 12Investment Grade Spread Targets Investment Grade Spread Targets Investment Grade Spread Targets Finally, the combination of above-potential GDP growth and a patient Fed is positive for spread product. Investors should remain overweight spread product versus Treasuries in bond portfolios, focusing on Baa and junk rated corporate bonds. Spreads for those credit tiers remain wide compared to historical median levels for this phase of the cycle (Charts 12 &13).7 Chart 13High-Yield Spread Targets High-Yield Spread Targets High-Yield Spread Targets Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bostonfed.org/news-and-events/speeches/2019/monetary-policymaking-in-todays-environment.aspx 2 https://www.chicagofed.org/publications/speeches/2019/risk-management-and-the-credibility-of-monetary-policy 3 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 7 For further details on how we calculate these spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification